Do earthquakes shake stock markets?

Summary

The research examines how major earthquakes affected the returns and volatility of aggregate stock market indices in thirty-five financial markets over the last twenty years.

Situation

Over the past few decades the world has witnessed an increase in the reported frequency and damages caused by natural disasters, particularly hydro-meteorological disasters. A growing literature has begun to analyze their economic and broader socio-political impacts. The majority of economic studies evaluate the short- and long-run impact of natural disasters on macroeconomic indicators, primarily gross domestic product (GDP) and its annual growth. While the findings are sometimes inconclusive, the general consensus is that disasters do not always negatively impact GDP growth or long-term GDP but that when they do, the negative impacts are larger for developing countries. We use an alternative approach to estimate the aggregate economic impacts of natural disasters by investigating whether earthquakes are capitalized into global stock markets. The literature analyzing the impact of natural disasters on capital markets is scarce and consists mainly of case and event studies estimating the impact of "domestic" disasters on specific sectors such as insurance, construction, and real estate. In contrast, we focus on aggregate stock market performance. Provided that aggregate stock market indices are a fair representation of the future prospects of overall (rather than sector-specific) economic performance, our approach can then be considered complementary to macroeconomic studies focusing on the impacts of earthquakes on GDP or GDP growth.

Response

Using an event study methodology in a GARCH-X(1,1) framework, we analyze the impact of the largest 24 earthquakes that happened over the last two decades across the world on the returns and their volatility in the aggregate stock market indices of 35 different financial markets. Our analysis focuses on the immediate, not the prolonged, impact of those large earthquakes on stock markets. Provided stock markets are relatively efficient, the impact of earthquakes should be reflected in short-run stock price changes. These price changes signal market beliefs about expected changes in future profitability arising from the occurrence of the disaster. We explicitly address the heterogeneity of impacts of the "average" large earthquake in different financial markets and investigate the channels through which stock markets may capitalize earthquake shocks. To this end, we take into account a number of factors that may mitigate or exacerbate earthquake impacts on returns. We classify these factors into two broad categories: (1) indicators of the proximity between financial markets and earthquake locations, including trade linkages between the country experiencing the earthquake and the country/region where the financial market is located, and geographical distance between the epicenter of the earthquake and the financial market; (2) indicators of the potential vulnerability and exposure of the economy to shocks, including GDP per capita and trade openness, in both earthquake and financial market countries/regions. We also control for earthquake characteristics (magnitude, death toll, and affected population) and for whether the earthquake resulted in a tsunami.

Impact

We find no systematic effect of earthquakes on the returns of aggregate stock market indices, which suggests that international financial markets are resilient to large earthquake shocks. On average, some macroeconomic variables (notably GDP and trade openness) and earthquake characteristics (magnitude, whether it resulted in a tsunami, distance to the epicenter, and fatalities) are found to mediate the impact of earthquakes on abnormal returns, but in the very few cases in which these variables are found to be statistically significant their influence is highly market-specific. Our results indicate that earthquakes did increase the volatility of the stock market in Japan, but not of other markets.

State Issue

Other Issue

Details

• Year: 2015
• Geographic Scope: International
• County: Clarke
• Program Areas:
  • Agriculture & Natural Resources