DO MARKETS PRICE WAR RISK? THE CASE OF INDO-PAK TENSIONS AND PSX INDEX VOLATILITY

Abstract

This study provides a rigorous empirical investigation into whether financial markets systematically price the risk of interstate war, with a specific focus on the Pakistan Stock Exchange (PSX) as a frontier market exposed to persistent Indo-Pakistani geopolitical tensions. Analyzing the decade from 2016 to 2025, which encompassed major crises such as the 2019 Balakot airstrikes and the severe 2025 Pahalgam/Bunyan al Marsous military escalation, the research employs a dual-methodology quantitative framework. Event study analysis is used to capture acute market reactions, revealing significant negative cumulative abnormal returns as high as -9.32% following conflict shocks. Simultaneously, longitudinal Generalized Autoregressive Conditional Heteroskedasticity (GARCH) models are employed to demonstrate that these geopolitical events induce immediate and persistent spikes in conditional volatility, embedding a lasting risk premium. The findings robustly confirm that the PSX prices conflict risk as a significant, non-diversifiable factor, transmitted through discount-rate, cash-flow, and sentiment channels. Notably, the market exhibits discriminatory pricing, reacting with greater intensity to direct military engagements than to periods of diplomatic friction. This research contributes critical evidence to the literature on geopolitical asset pricing in non-Western frontier markets and underscores the direct financial stability costs of regional hostility. The implications are vital for international portfolio risk management, strategic asset allocation, and policymaking aimed at mitigating the economic repercussions of geopolitical instability.