Political Conflict and Foreign Portfolio Investment : Evidence from North Korean Attacks

We examine the response of foreign investors to escalating political conflict and its impact on the South Korean stock market surrounding 13 North Korean military attacks between 1999 and 2010. Using domestic institutions and domestic individuals as benchmarks, we evaluate the trading behavior and performance of foreign investors. Following attacks, foreigners increase their holdings and buy more shares of risky stocks proxied by high book-to-market ratios. Performance results show foreigners maintain their pre-attack level of performance while domestic individuals, who make the overwhelming majority of domestic trades, perform worse. Domestic institutions improve their performance. Overall, the results are consistent with the predictions based on the benefits of international diversification. Foreigners trade more shares than usual, providing more liquidity while domestic individuals trade substantially less. Foreigners also deviate from their general strategy of positive feedback trading, a strategy that could destabilize the market further in the short run