International Stock Market Co-Movements and Politics-Related Risks
72 Pages Posted: 25 Mar 2019
Date Written: March 12, 2019
We investigate the determinants of international stock market co-movements, shedding light on the relevance of politics-related factors. We propose a new characterization for the link connecting politics and financial markets, disentangling two different components: political risk and economic policy risk. We uncover the surprisingly low correlation between the two variables, and show they are priced differently by the market. We implement a pairs trading strategy, in the spirit of Gatev et al. (2006), which loads on international stock market co-movements. Exclusively relying on hard macro-data proves not to be sufficient to explain the statistically significant and economically large returns generated by the strategy. We show how to increase the abnormal returns (alphas) generated by the strategy by exploiting shorter-time co-movements. We document the utmost relevance of political risk, which explains and predicts returns driven by both short-term and long-run correlations. Our analysis also unveils the relevance of confidence factors, especially foreign investors' confidence, which should therefore be accounted for when assessing the co-variation of international stock market prices.
Keywords: international stock markets, political risk, economic policy risk, pairs trading, predictive regressions, CDS spreads, abnormal returns
JEL Classification: G12, G15
Suggested Citation: Suggested Citation