Political Risk Spreads
51 Pages Posted: 30 Nov 2013 Last revised: 6 Aug 2014
Date Written: December 22, 2013
We introduce a new, market-based and forward looking measure of political risk derived from the yield spread between a country’s U.S. dollar debt and an equivalent U.S. Treasury bond. We explain the variation in these sovereign spreads with four factors: global economic conditions, country-specific economic factors, liquidity of the country’s bond, and political risk. We then extract the part of the sovereign spread that is due to political risk, making use of political risk ratings. In addition, we provide new evidence that these political risk ratings are predictive, on average, of future risk realizations using data on political risk claims as well as a novel textual-based database of risk realizations. Our political risk spread measure does not make the mistake of double counting systematic risk in the evaluation of international investments as some conventional measures do. Furthermore, we show how to construct political risk spreads for countries that do not have sovereign bond data. Finally, we link our political risk spreads to foreign direct investment. We show that a one percent point reduction in the political risk spread is associated with a 12 percent increase in net-inflows of foreign direct investment.
Keywords: Political risk, Country risk, Sovereign spreads, Political risk news, Risk realizations, OPIC, Foreign Direct Investment, FDI, Cost of Capital, Political turmoil, Expropriation risk, ICRG, Coplin-O'Leary
JEL Classification: F21, F23, F36, G15, G31, H25, K33, M21, O16, O19
Suggested Citation: Suggested Citation