Rare Disasters and Exchange Rates: An Empirical Investigation of South Korean Exchange Rates under Tension between the Two Koreas

We investigate the implications of the disaster hypothesis proposed that changes in the probability of the outbreak of a rare disaster and/or expected damage caused by a rare disaster can make exchange rates fluctuate. Assuming that news articles reporting North Korea's actions that raise tensions on the Korean peninsula affect the probability and expected damage of a disastrous war in the region, we find that the South Korean exchange rate depreciates significantly in response to such news articles with the application of a nonparametric approach. We also show through an event study that the South Korean exchange rate depreciates significantly immediately after nuclear tests, although the duration of the significant depreciation is short. These findings are another piece of evidence for the exchange rate disconnect puzzle. Finally, we observe that the response of the exchange rate to news escalating tension levels in Korea varies over time and that the time variability of the response is similar to the habituation learning process.