Terrorism and Its Impact on the Cost of Debt

Abstract

We extend the literature on the costs of terrorism by examining its long-term impact on financial markets, an underdeveloped strand of research within the terrorism construct. Specifically, we look at its effect on sovereign risk, which forms the basis of the cost of debt in affected countries, postulating that it results in a lower credit rating and that this impact is more pronounced in developing markets as opposed to developed markets. In operationalizing the risk of terrorism, we utilizes the Institute for Economics and Peace’s Global Terrorism Index, the most comprehensive index constructed to date which incorporates both the economic and social dimensions of terrorism and is based on the Global Terrorism Database. The results of the study support the hypothesis that terrorism results in a higher cost of debt for sovereigns and by extension, firms in impacted countries. In fact, a 10% increase in terrorism on average results in a 2.1% reduction in a sovereign’s credit rating, or half a notch (which is roughly equivalent to a change in outlook). Furthermore, this impact is much more pronounced in developing markets where the authors find that a 10% increase in terrorism result in a very material 13% decrease in the sovereign credit rating, which is equivalent to almost three ratings notches, or an entire letter class (e.g., from BBB to BB).