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The IUP Journal of Applied Finance
The Impact of Political Instability on Investor Sentiment and Market Performance: Evidence from Tunisian Revolution
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This paper studies the impact of political instability on stock market dynamics by comparing the interaction between market returns, volatility and investor sentiments before and after the Tunisian revolution. The results of the estimation of simultaneous equations—GMM 2S method—linking the return, risk and investor sentiment confirm that during the period of political stability, investor sentiment did not affect market return and volatility. However, during the period of the Tunisian revolution and thus political instability, significant bidirectional relationship between investor sentiment and market volatility and return is highlighted. These results confirm that investors’ behavior compounds the political instability effect on Tunisian market.

 
 
 

In financial literature, several studies have focused on the impact of political instability on financial market performance. Barro (1991), Easterly and Rebelo (1993), Alesina and Perotti (1996), and Persson and Tabellini (2006) find that government, social instability and political violence often negatively affect growth. Jong-a-Pin (2009) finds that higher degrees of political instability lead to lower economic growth. Sidra et al. (2009) confirm that there is a significant influence of political events on trading volume and stock returns in Karachi Stock Exchange. As regards private investment, Alesina and Perotti (1996) show that socio-political instability generates an uncertain politico-economic environment, raising risks and reducing investment. Political instability also leads to higher inflation as shown by Aisen and Veiga (2006). Large empirical finance literature documents that the investors’ sentiment largely affects the market dynamics (Lee et al., 1991 and 2002; Brown and Cliff, 2005; Baker and Wurgler, 2006; Kumar and Lee, 2006; Baker and Wurgler, 2007; Edmans et al., 2007; and Ho and Hung, 2009). The existence of sentiment-driven investors can cause prices deviate from the fundamental values mainly if rational traders cannot exploit the arbitrage opportunities. These researches are motivated by behavioral theories that focus on the influence of emotions and cognitive bias on people’s judgments and decision making (Loewenstein et al., 2003). Indeed, the emotional and cognitive reactions of the investors have a great influence on their eventual decision (Simon, 1967 ). In this sense, it has been documented that market dynamics can be influenced by the changes in the investors’ mood. Consequently, investors in a good mood tend to be more optimistic in their decisions than those in a bad mood (Wright and Bower, 1992). Any change in their behavior is reflected in stock prices (Antoniou et al., 2013). Political events also have an impact on the psychology of investors. Clark and Tunaru (2001) examined the impact of political risk on the Pakistan Stock Exchange during the period 1947 to 2001, concluding that political events have an influence on the stock market returns of the country. Nikkinen and Vahamaa (2010) analyze the reaction of the FTSE 100 index after the terrorist attacks of September 11, 2001 in the US, of March 11, 2004 in Madrid, and July 7, 2005 in London. They show that these attacks are transforming investors’ expectations downwards.

 
 
 

Applied Finance Journal, Impact of Political Instability,Investor Sentiment and Market Performance, Evidence from Tunisian Revolution.