Figures 4.1 to 4.4.
9200.009000.003/13/03Imminent prospect of war inIraq.
8800.008600.008400.008200.00
3/13/03date.open 7555.29date.high 7824.34date.low 7555.29date.close 7821.75
8000.003/20/03War begins.
7800.00
CHAPTER 4 • GEOPOLITICAL EVENTS
9400.00
7600.007400.001/2/03
2/2/03
3/2/03
4/2/03
5/2/03
6/2/03
Reaction of the DJIA to the imminent prospect of war in Iraq. Daily trading range of the DJIA from January 1, 2003 to June 30, 2003.
FIGURE 4.1
Stocks rally as war approaches.
93
94
40.0039.00
3/13/03date.open 37.85date.high 38.14date.low 35.75date.close 36.01
38.003/13/03Imminent prospect of war inIraq.
37.0036.0035.0034.0033.0032.0031.0030.0029.003/20/03War begins.
28.0027.0026.0025.001/2/03
2/2/03
3/2/03
4/2/03
5/2/03
6/2/03
Reaction of NYMEX front month crude oil futures prices to the imminent prospect of war in Iraq. Daily trading range of NYMEX crude oil futures prices from January 1, 2003to June 30, 2003.
FIGURE 4.2
Crude oil prices fall.TRADING CATALYSTS
1.19001.18001.17001.16001.15003/13/03Imminent prospect of war inIraq.
1.14001.13001.1200
3/20/03War begins.
1.11001.10001.0900
3/13/03date.open 1.0993date.high 1.0997date.low 1.0774date.close 1.0778
1.08001.07001.0600
CHAPTER 4 • GEOPOLITICAL EVENTS
1.2000
1.05001.04001.03001/1/03
2/1/03
3/1/03
4/1/03
5/1/03
6/1/03
Reaction of the euro/dollar exchange rate to the imminent prospect of war in Iraq. Daily trading range of the euro/dollar exchange rate from January 1, 2003to June 30, 2003.
FIGURE 4.3
The euro falls against the dollar.
95
96
121.00120.00119.00118.00117.00116.00115.00114.00
3/13/03Imminent prospect ofwar in Iraq.
113.00112.00
3/20/03War begins.
111.00110.00
3/13/03date.open 111 24/32date.high 111 30/32date.low 109 17/32date.close 109 19/32
109.00108.00107.00106.00105.00104.001/2/03
2/2/03
3/2/03
4/2/03
5/2/03
6/2/03
FIGURE 4.4
Treasury bond futures prices fall.
TRADING CATALYSTS
Reaction of 30-Year Treasury bond prices to the imminent prospect of war in Iraq. Daily trading range of 30-year Treasury bond prices from January 1, 2003to June 30, 2003.
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They are also captured in the following excerpt from Reuters thatwas disseminated at 7:53 P.M. (New York time) on Thursday, March13, 2003.Stocks rallied everywhere but Japan on Thursday and the dollar climbed, while U.S. bonds and gold prices fell on hopesthat any war with Iraq might be short—or perhaps avoidedthrough diplomacy.…Wall Street’s surge proved to be contagious, and Tokyo’sNikkei was up 1.92 percent or 151 points at 8,019.59 in earlyFriday morning trading…On Thursday, the dollar jumpedafter television network CNN reported during Asian tradinghours that Iraqi officials may have begun secret negotiationsto surrender.Bond prices tanked in the U.S. Treasury market’s worst selloffin three months. Gold hit a three-month low.In New York, crude oil futures plummeted almost $2 a barrel,a drop of about 5 percent, on news that the United NationsSecurity Council may delay until next week a vote on a U.S.and British resolution to authorize war against Iraq.4As is sometimes the case with trading catalysts, the appropriateinterpretation of the reason for the price moves is controversial. Didstocks rally on the prospect of a short war or did they rally in thebelief that war could be averted or delayed? The preceding excerptssuggest that it could be either. Other commentators also explicitlyrecognized the conflicting reasons for the sharp moves in commodityand financial market prices.5 Some news reports took a more narrowview and argued that the market rallied in the belief that war withIraq could be avoided or delayed.6Factors internal to the market helped fuel the rally. In this case,the stock market rally was exacerbated by short-covering.7 Although itis possible that the market reacted to the potential for the war to beaverted, it seems more likely that the market anticipated that a war
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would break out soon and that coalition forces would win a quick anddecisive victory. The reason is as follows.At the time, it was commonly believed by many market participants that there was a $4 to $5 per barrel war premium in the price ofoil. This meant that a quick resolution of the conflict could trigger asteep decline in oil prices. In addition, many observers believed thatuncertainty about whether there would be a second war with Iraqacted as a drag on the economy. The trading thesis that likely prevailed was that the war would be short and military success wouldprecipitate a sharp decline in oil prices and enhance the prospects forU.S. economic growth.8The market’s reaction to the prospect of a short war with Iraq alsoillustrates the influence of past events in guiding the market’s likelyresponse to current events. The early and easy success of coalitionforces in the 1991 Gulf War triggered a massive market reaction asdetailed in the following excerpt from The Wall Street JournalEurope on Thursday, January 18, 1991.Stocks in the U.S. rocketed 4.6% in euphoric trading, pushingthe Dow Jones Industrial Average 114.60 points higher to2623.51, the second-biggest point gain ever. Oil and goldprices plunged in a stunning reversal to their initial run-upwhen the war erupted. Crude for February delivery plummeted a record $10.56 a barrel to $21.44; February golddived $30.10 an ounce to $374.40.The dollar skidded as the apparent success of air attacks onIraq led traders to believe the gulf war will be short…U.S.Treasurys rose on the early news from the Mideast. The30-year bond was quoted Thursday at 106 2-32, up 211-32…London stock prices surged 2.4%…Share pricesjumped throughout the Asian-Pacific region…In Tokyo, theNikkei stock average increased 4.5%…9The market’s reaction to the success of coalition forces in the1991 Gulf War provided traders with a road map of how the market
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would likely react to the second Iraq war if it occurred. The imposition of sanctions on the Iraqi regime after the Gulf War ended meantthat the Iraqi military was less prepared than it was before the GulfWar even if the sanctions were only partially effective. This meantthat if a second war began with Iraq it would also likely be short withminimal losses on the coalition side. After the prospect of warbecame certain, the only question was when it would begin. Tradersdid not want to miss the likely moves in the market by waiting untilthe war actually started. This illustrates the market’s tendency to telescope, or shorten, its reaction time to current events when the reaction is largely based on how the market responded to similar events inthe past. If the market reacted the day after the Gulf War started in1991, it is not surprising that the market reacted as soon as a secondwar with Iraq became a virtual certainty. As shown in Chapter 2,“Market Conditions and Sentiment,” a similar phenomenon occurredin May 2005 in the steep and immediate reaction of Treasury bondprices to the announcement that the Treasury Department was considering issuing 30-year Treasury bonds again. The combined two-dayrally of almost 9 points that occurred on October 31 and November 1,2001 was telescoped to an almost immediate 8.5 point decline in longbond prices a few minutes after the May 4, 2005 announcement thatthe Treasury was considering reissuing 30-year bonds.In order to appreciate the market’s behavior on March 13, 2003,it is important to understand the significance of geopolitical factors astrading catalysts in the run-up to the second war with Iraq. Theprospect of a second war between Saddam Hussein’s Iraq and theU.S. and its allies jumped after the September 11, 2001 terroristattacks on the United States with unsubstantiated claims of Iraqiinvolvement in promoting terrorist actions against the U.S. It jumpedfurther with faulty intelligence that suggested that Iraq possessedweapons of mass destruction. The almost 18-month period after theSeptember 11, 2001 terrorist attacks until the war began on March20, 2003 was a period in which geopolitical events frequently roiled
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financial markets. During this period, even speeches in the UnitedNations or the passage of resolutions by the United Nations SecurityCouncil could impact world markets. Not surprisingly, commodityand financial markets were subjected to periodic bouts of volatility asthe prospect of war increased or decreased.It is instructive to examine the price action of several key commodity and financial markets over the months preceding the secondwar with Iraq. Interestingly, the markets did not move in unison. Forexample, gold—which is often viewed as a safe haven in times oftrouble—peaked in January almost two months before the surprisestock market rally of March 13. Similarly, the Japanese yen hadreached a similar level to where it traded on March 13 in late February 2003 before selling off and rallying again. Crude oil was on asteady uptrend from November 2002 when it traded around $24 perbarrel. Although the prelude to the second Iraq war was the dominant factor in the markets during late 2002 and early 2003, other factors specific to each market were also important. For instance, crudeoil prices were pushed up by oil-worker labor disputes in Venezuela.The behavior of the various markets after the war started is equallyinteresting as prices bounced around in reaction to press reports ofmilitary actions and Iraqi resistance.
Geopolitical Events as Trading CatalystsPolitics and finance intersect in the impact that the actions of governments and electorates have on financial markets. The reaction offinancial markets to various political events around the world createsnew trading opportunities and exposes traders to another type ofrisk—geopolitical risk. Traders are not interested in politics, per se,but rather the impact that various political actions or their prospectshave on market prices and volatility. Geopolitical events are anothersource of trading catalysts.
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Geopolitical events may take a variety of types ranging from nonviolent to violent. Wars, revolutions, coups d’etat, assassinations, andterrorist actions are examples of the violent types of geopoliticalevents. Such events often exert a profound impact on financial market prices. The events leading up to the Iraq war in March 2003exemplify the impact of geopolitical risk on financial markets.Financial markets have long responded to the outcomes of theindividual battles that wars are comprised of. For instance, during theNapoleonic wars, information from the battles affected the value ofgovernment “stock” (i.e., British government debt), also known asgilts. It is said that the London branch of the Rothschild family madea fortune when it found out that Lord Nelson had won the Battle ofWaterloo. The use of carrier pigeons gave the Rothschilds a technological and informational edge over their rivals. Their rivals knew thatthe Rothschilds possessed an informational edge and the Rothschildsknew that their rivals knew that they had an informational edge. Itwas readily apparent that news of Lord Nelson’s victory would spark ahuge rally in gilt prices. Consequently, it is alleged that when NathanRothschild found out that Lord Nelson had won the battle of Waterloo, he promptly sold gilts knowing that other traders would believethat the information Rothschild possessed (presumably about theoutcome of the battle of Waterloo) was negative for gilts. This, inturn, sparked panic selling of gilts. Rothschild then was able to buyeven more bonds for a fraction of what he would have had to paymoments earlier.Nonviolent types of geopolitical events can also exert a substantialimpact on financial market prices. As was mentioned in Chapter 1,“Introduction,” the assassination of President John F. Kennedy on Friday, November 22, 1963 precipitated a sharp drop in stock prices andthe early closure of the New York Stock Exchange. The marketremained closed on Monday, November 25 but experienced a massiverally when it reopened on Tuesday, November 26.10 Examples of nonviolent types of geopolitical events include: elections, expropriations,
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TRADING CATALYSTS
and changes in tax rates or regulatory policy. The outcomes of elections may pose a real or imagined threat to the economy and, henceasset prices, likewise, the outcomes of referenda. In addition to affecting the level of market prices, geopolitical risk may affect the volatilityof financial markets. Increased volatility makes options more expensive and may adversely affect liquidity if trading volume falls substantially as a result. Geopolitical events may also change the prevailingmarket sentiment as well as the economic outlook.Individuals who have a talent in anticipating the outcome of elections and referenda or in discerning the likely course of politicalevents may have a trading edge provided they are also able to assesscorrectly the likely market reaction to those political events. Such atrading edge may be valuable episodically, perhaps only a few times ayear. This requires that traders trading off of their comparativegeopolitical expertise limit their trading accordingly. It may alsorequire that such traders assume larger position sizes when they puton a trade than they might otherwise do if they were trading morefrequently.
The Arrest of Mikhail KhodorkovskyOn Saturday, October 25, 2003, Mikhail Khodorkovsky, head of theRussian oil company Yukos and the wealthiest man in Russia, wasarrested by Russian police in Novosibirsk, Siberia. Khodorkovsky wassubsequently charged with fraud and tax evasion. Despite the prediction by Deputy Prime Minister and Finance Minister Alexei Kudrinthat there would be no significant market reaction to Khodorkovsky’sarrest, the Russian stock market plummeted and the rouble fellsharply when the market opened on Monday, October 27.11 The principal index of the Russian market, the Russian Trading System (RTS),was down over 14% before bouncing back to close down just over
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10%.12 Not surprisingly, Yukos shares were more severely affected, atone point losing more than 20% of their value before closing downover 15%.13The arrest of Khodorkovsky was seen (correctly or not) as politicallymotivated and a form of retribution by the government. (Khodorkovsky had financed opposition to Russian President Vladimir Putin.)Traders had to assess whether Khodorkovsky’s arrest meant a return toold ways of doing business in Russia. They also had to determinewhich markets would be affected and the likely magnitude of theimpact. Although there was little reason to suspect that Khodorkovsky’s arrest would impact markets in the developed world, it couldadversely affect other emerging markets by affecting foreign investors’appetite for risk. It did not. The impact of the arrest was limited toRussian financial markets and did not impact foreign markets.A trader did not have to have prior knowledge of Khodorkovsky’sarrest to make money from its impact on financial market prices. Thelarge drop in Russian stock prices on Monday, October 27, 2003 created the potential for a rebound. Part of the rebound came on Monday when stock prices bounced off their lows of down almost 14% toclose down over 10.6%. Russian financial markets recovered somewhat more with a 2.5% bounce in the RTS index on Tuesday, October28, 2003.
ElectionsThe surprise outcomes of elections and referenda sometimes serve astrading catalysts, inducing a significant change in market prices.Because both elections and referenda are scheduled political events,information about consensus expectations is frequently availablethrough opinion polls. This tends to reduce the number of surpriseoutcomes but probably increases the market impact of any surprise. Itshould be noted that survey results from opinion polls may fluctuate
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more than actual consensus expectations. This means that opinionpolls are often less reliable than market assessments.
May 2004 Indian Parliamentary ElectionIndian parliamentary elections (which occur in stages) were heldbetween April 20, 2004 and May 10, 2004. The surprise loss of IndianPrime Minister Atal Behari Vajpayee’s Bharatiya Janata Party (BJP)and the presumptive election of Congress Party leader Sonia Gandhias prime minister prompted a sharp selloff in Indian equities.14 Theselloff in Indian stock prices started with exit poll results and climaxed in a 16.62% decline in Indian share prices on Monday, May17, 2004 before rallying to close down only 11.14% after “powerfulstate-run financial institutions” were instructed to buy shares.15 Putdifferently, the market capitalization of Indian stocks fell by $40 billion on May 17. It is important to emphasize that there was ampletime for traders who believed that the new government was bad forthe market to put on a significant short-equity position. Indeed, themarket was down around 6% the previous week after news of theelection results first broke. Not only did the market continue todecline a week after the news was out but the magnitude of thedecline increased.Once again, the market reaction was exacerbated by market participants who were forced to sell stock bought on margins—that is,the external trading catalyst (the likely election of Sonia Gandhi asprime minister) was less important than the internal trading catalyst(margin calls and the positive feedback trading it induced). In otherwords, lower prices resulted in more margin calls, which in turnpushed stock prices even lower. The sharp decline in stock pricesoccurred despite two trading halts that temporarily suspended trading after the overall market was down 10% and again when the overall market was down 15%. This is described in the May 18, 2004 issueof the Business Standard.
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…The dramatic collapse in the Bombay Stock Exchange(BSE) Sensex today [Monday] had its origins in Friday’s 330point decline that triggered huge margin calls on brokers andinvestors. This, in turn, forced them to sell heavily to raisecash, setting the stage for a hugely negative start today. TheSensex opened 100-150 points below Friday’s close, whichmade the subsequent 842-point intra-day crash and two trading stoppages a self-fulfilling trend…In today’s trading, there was no hint of panic till the Sensexfell 200 points, but around this point cascading margin callsforced speculators and big investors to keep selling in orderto raise cash. …With margins as high as 80 per cent beingcalled for, the market saw only sellers most of the time…16Selling as the result of margin calls explains part of the magnitudeof the decline in Indian stock prices. Not surprisingly, foreign institutional investors were blamed for instigating much of the selling.17(However, no evidence of market manipulation was reported by theSecurities and Exchange Board of India—the governmental regulatory agency—in a subsequent investigation.)18 The delayed reactionto the Indian parliamentary elections was largely localized with limited impact on foreign markets. It should be noted that there was asignificant intraday bounce as the market went from being down16.6% to closing down 11% after large domestic institutional buyorders came to the market.The concern of market participants supposedly centered on theselection of Sonia Gandhi as prime minister and uncertainty over theeconomic policies that the Congress Party would pursue with its leftwing coalition partners. The decision by Sonia Gandhi not to seek theposition of prime minister coupled with the selection of ManmohanSingh—a respected former finance minister in a previous Congressgovernment—as the new prime minister served as a trading catalyst.News of Manmohan Singh’s selection as prime minister designateprecipitated an 8.5% rally in Indian stock prices.19 The magnitude of
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TRADING CATALYSTS
the rally also reflected the likely overreaction the previous day due tomargin sales.Knowing the likely source of selling pressure in any break allowstraders to ascertain whether a price decline is overdone—that is,traders need to be able to assess the potential for positive feedbacktrading from margin calls, stop-loss orders, technical analysis, shortcovering, or other sources. In turn, this allows traders to positionthemselves for the potential subsequent rebound in market pricesand assess the potential magnitude of the rebound in prices.
The Brazilian Presidential Election of 2002The prospect of the election of Luiz Inacio Lula da Silva as presidentof Brazil in October 2002 sparked periodic declines in the Brazilianstock market, Brazilian government bonds, and the foreign exchangevalue of the real, Brazil’s currency unit, as the odds of Lula’s electionincreased. For instance, a weekend poll indicating a significant rise inLula’s support sparked a 3.5% decline in the Brazilian stock market, a5% decline in the key Brazilian government bond, and a 4.8% declinein the value of the real against the dollar on Monday, September 23,2002.20Perhaps a more dramatic effect of the 2002 Brazilian presidentialelection campaign was the impact on the bond market. The spread ofBrazilian government dollar-denominated debt over comparablematurity U.S. Treasury debt is a measure of country risk. In therun-up to the election of Mr. Lula da Silva as president of Brazil, thespread of Brazilian dollar-denominated C bonds over comparablematurity U.S. Treasury bonds widened to 2436 basis points on Friday,September 27, 2002.21This is a tremendously wide spread, or put differently, a substantial increase in Brazil risk. To put it in perspective, 2400 basis pointsmeans that if 10-year U.S. Treasury notes were yielding 6%, 10-yeardollar-denominated Brazilian debt would be yielding 30%. Although
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the spread was at its widest shortly before the first round of the presidential election, it should be noted that the increase in the spreadover its normal level took place over a period of several months.Not surprisingly, the yield spread widened as the probability ofLula’s election as president increased. However, this is only part ofthe story. To be sure, the level of the spread conveys the sense ofpanic that existed among some participants in the Brazilian bondmarket over Lula’s likely election as Brazil’s president; but it also conveys the impact of other factors. Factors internal to the market alsoplayed a significant role in the widening of the spread. In particular,the spread increased as the result of hedging activities of sellers ofcredit protection of Brazilian dollar-denominated C bonds.22 This isyet another illustration of the importance of understanding the likelybehavior of market participants. Dealers who sell protection againstcredit risk want to hedge their position, especially if prices start tomove against them. In this case, dealers who had sold protectionagainst the risk that Brazil would default protected themselves byselling Brazilian C bonds that they did not own. The rush to hedge bydealers pushed Brazilian C bond prices sharply lower, which encouraged more dealers to hedge themselves by shorting the Brazilian Cbond, and in turn, exacerbated the downward move in bond price andincrease in yield. The hedging activity by dealers can create yielddistortion among bonds with seemingly similar risks.23
1992 Maastricht Treaty ReferendumThe Treaty of Maastricht (also known as the Treaty on EuropeanUnion) was agreed upon by European Community governments onFebruary 7, 1992.24 The purpose of the treaty was to promote economic integration by establishing a European Monetary Union(EMU). The treaty required ratification by all European Communitymember governments. On June 2, 1992, Danish voters were given
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the opportunity to vote for or against the Maastricht treaty in a referendum. In a surprise result, Danish voters rejected the treaty by avote of 50.7% to 49.3%.The outcome plunged the European Community into crisis mode.The outcome of the Danish vote, coupled with the prospect of aFrench referendum on the same issue, impacted financial marketswith most European stock markets closing lower.25 Besides impactingstock prices, the outcome of the Danish referendum also sparked arise in the dollar against both the Danish krone and the Germanmark.26 In addition, the outcome of the referendum prompted manyEuropean bonds (especially European Currency Unit (ECU) denominated bonds) to fall, whereas German mark denominated bondsrose.27At first glance, the duration of the market impact of the Danishrejection of the Maastricht seems relatively limited as the dollar fellagainst the German mark and stock prices recovered on Thursday,June 4, 1992.28 However, the real impact of the Danish vote was tochange sentiment about the viability of the European MonetaryUnion. In fact, it might be argued that the result of the Danish referendum was to set in motion a wave of bets against the EMU, whichultimately resulted in the Black Wednesday, September 16, 1992 currency realignment when the Bank of England was forced to withdrawfrom the EMU and let the pound sterling float.Finally, it should be noted that Danish voters eventuallyapproved the Maastricht treaty. After receiving a number of rights toopt out of certain provisions of the treaty, voters in Denmarkapproved the Maastricht treaty by a vote of 56.7% to 43.3% onMay 18, 1993.
2005 European Union Constitution ReferendaOn October 29, 2004, the treaty establishing a European Union Constitution (or, more simply, the European Constitution) was signed by
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all 25 European Union (EU) member governments. The idea was toreplace a set of existing treaties with a single treaty among EU member states, change relative voting powers, clarify individual rights, andsimplify decision making. Implementation of the treaty required formal ratification of all the member states—some of whose governments decided to put ratification of the proposed treaty to a voteamong their citizens. France was one such government. The Netherlands was another. Although citizens were restricted to voting yes orno, the European Constitution referenda became vehicles by whichdissatisfaction with the policies of the government in power or theEuropean Union could be expressed.The growing prospect of a French no vote acted as a catalyst indriving down the foreign exchange value of the euro against the dollarand changing market sentiment as contemporary news reportssuggest.29On Sunday, May 29, 2005, French citizens rejected the proposedEuropean Constitution by a vote of almost 55% to 45%. The electionresults, despite being widely expected, acted as a trading catalyst onfinancial markets. The euro fell in response to the news on Monday,May 30, 2005 and again on Tuesday, May 31, 2005 for a total of2.2%.30 This is depicted in Figure 4.5.On June 1, 2005, Dutch voters rejected the European Constitution by almost 62% to 38%. The result of these two back-to-backrejections of the European Constitution was to cast doubt on theeventual ratification of the treaty, but more importantly, on the vitality of the European Union itself. The euro fell an additional centagainst the dollar on news of the defeat of the proposed treaty byDutch voters.31
110
1.32001.3100
5/30/05date.open 1.2510date.high 1.2571date.low 1.2458date.close 1.2474
1.30001.29005/30/05
1.2800
5/31/05date.open 1.2474date.high 1.2488date.low 1.2297date.close 1.2303
1.27005/31/05
1.26001.25001.24001.23001.22001.21001.20001.1900
5/1/05
6/1/05
7