Stock market interdependence during the Iraq war

This paper aims to show how consolidated and innovative methodologies can be employed to assess the financial impact of a global shock. Particularly, we consider the Iraq War in 2003 and its impact on the market indexes of five of the most capitalised stock markets in the world, U.S., U.K., France, Germany and Italy. After using an event study methodology to assess the direct impact of War events on the five selected markets, we extensively analyse the correlation between these markets. Since cross-market correlation coefficients are conditional on market volatility, tests for market interdependence based on these coefficients are inaccurate due to heteroskedasticity. Therefore, during crises when markets are more volatile, like during the Iraq War, estimates of correlation coefficients tend to increase and be biased upward. We correct for the bias as proposed by Forbes and Rigobon (2002) and estimate the time-varying correlation index using the Kalman filter methodology. Our research objective is to verify whether during the conflict the correlation among markets varied significantly. We find that correlation increases between Italy, U.K. and France whereas it decreases between these markets and both U.S. and Germany. We explain this behaviour building up a Country-specific exposure index considering jointly the direct involvement in the War and the economic linkages with Iraq, measured in terms of oil imports.