Nonlinear Analysis

Non-linear link between political instability and stock market performance:

The growing importance of nonlinear analysis on financial and real sector dated back to early 1990s. Hsieh (1991) and Brock (1992) provides a general argument why research on nonlinear science in general and chaos in particular is important in economics and finance. Add to that, by providing methodological reasons for nonlinear analysis in Financial Economics, Hiemstra and Kramer (1998) state that ‘linear asset-pricing relations omit interesting useful aspects of the relationship between stock returns and the macro economy’. Nonlinear models can have sudden bursts of volatility and occasional large movements [Hsieh (1991:1840)]. Sudden booms or drops of stock prices

For instance, while, Hasanov and Omay (2008) examined the potential nonlinearities in two emerging stock markets in Europe; Greek and Turkey, Chen (2008) investigated the issue of nonlinearity of stock prices in 11 OECD countries. Recently, Mcmillan (2012) examined the usefulness of nonlinear models to provide accurate estimations and forecasting using UK stock and bond returns. Bonga-Bonga and Makkabule (2010) examine the relationship between stock returns and macroeconomic variables in South Africa using a nonlinear approach. However, it should be noted that many of these studies employ regime switching models for time series data; Markov switching or smooth transition models as their nonlinear

Yet, one should not forget that if such linear relationship truly exists in the real world, then the stock markets should be collapsed in military ruling countries, for example- countries like Thailand and Pakistan, which have experienced such military regimes in the recent past. In real world, what observed is with the announcement of military ruling or takeover, as the initial responses, stock market fluctuate significantly, but after sometime period stock market may again start to recover. The situation may be different, if the military takeover results in a continuous political tension and civil unrest, and the economy as a whole experiences a negative growth. Finally, it should be noted that investors, as many other ‘rational individuals’ take their decisions which may hugely shaped by their ‘learning by doing or experience’ behaviour. With more and more information on hand, nowadays stock market investors have enough sources to identify potential impact of sudden political changes by exploring the aftermath of such previous situations in history. To conclude, it is theoretically and empirically appealing to re-quantify the impact of political instability on stock market performances in a nonlinear framework, as the existing linear models may not be actually able to