How Investors React to Political Risk

Abstract:     
Investor reaction to political risk alternates: During or soon after a crisis, investors are quite reluctant to invest in politically risky securities, and will do so only at high 'lemons' discounts. After a period of calm, investors return, and bid down spreads to quite low levels-- levels that, after the next crisis, seem in retrospect too low. Investors are often depicted as overreacting to political risk: at times they are too scared,and at other times, they are not scared enough. My paper argues that while there may be some component of irrationality, the pattern of alternating skittishness and confidence may be the best even rational investors can do, as an investor's best guess about political risk may be that the future will be more like the recent past than the distant past. In other contexts, involving better-understood risks, heavily weighting recent events may be a cognitive mistake; in this context, where the 'correct' weighting is not known, it may sometimes be the best choice.

Political risk is quite heterogenous, rising to the level of Knightian uncertainty. Payoffs and probabilities are difficult to estimate with precision. Our knowledge does not cumulate very effectively; indeed, events may, not infrequently, prompt us to redefine what political risk is, and what results it can have for investors. But standard finance methodology is predicated on homogeneity: saying that an event with a particular payoff will occur with 20% probability implicitly conjures up multiple trials where 20% of the time, an event akin to -- in the same 'class' as -- the event being considered occurs. While few classes in the real world are homogeneous -- even coin tosses are in some respects different from one another -- most risks investors face can be treated as belonging to classes more homogeneous than political risk.

How, then, will investors react to political risk? At times of crisis, many investors may make a broad-brush determination to minimize their exposure to politically risky securities until they know more. After a period of calm, the spreads then being offered seem too high relative to the risks involved, more investors return, and the spread narrows. Eventually, there is another crisis and the cycle begins again.

Number of Pages in PDF File: 31

JEL Classification: G12, G14

Accepted Paper Series