Abstract

This paper analyzes the effect of recent political conflicts in the Middle East on stock markets worldwide. In particular, it studies how political instability-mainly due to the war in Iraq-has affected the long-term volatility of stock markets, using two approaches, Inclan and Jlao 's (1994) iterative cumulative sum of squares algorithm and wavelet-based variance analysis, to detect structural breakpoints in volatility. Controlling for conditional heteroskedasticity and serial correlation in returns, the paper finds that the ongoing Middle East conflicts have had an effect primarily on the stock markets of countries in the Middle East and in emerging Asian countries (e.g., Turkey, Morocco, Egypt, Pakistan, and Indonesia). Further evidence from an international version of the capital asset pricing mechanism shows that political instability in the Middle East has had a heterogeneous effect on the sensitivity of stock returns to market and currency risks. © 2007 M.E. Sharpe, Inc. All rights reserved.