Risk, Uncertainty, and the Perceived Threat of Terrorist Attacks: The Advisory System that Cried Wolf?

Abstract

Information provided by the U.S. Department of Homeland Security regarding potential terrorist attacks significantly affects the U.S. equity market. When the government raises the perceived threat level, investors’ perceptions of risk increase (as measured by the conditional volatility of returns and implied volatility on S&P 500 Index options), but these responses have declined monotonically over time. We also find evidence that informed traders are more active when there is an increased threat of an attack. Thus, the perceived threat of terrorism can affect both equity volatility and the information content of trades but not necessarily the level of aggregate returns.