Country Risk Components, the Cost of Capital, and Returns in Emerging Markets

30 Pages Posted: 18 Nov 2004

See all articles by Campbell R. Harvey

Campbell R. Harvey

Duke University - Fuqua School of Business; National Bureau of Economic Research (NBER); Duke Innovation & Entrepreneurship Initiative

Abstract

This paper examines the importance of political risk, the financial risk, and economic risk in portfolio and direct investment decisions. In addition, the components (from the International Country Risk Guide) of each of these risk measures are examined. The components of political risk include: Government Stability, Socioeconomic Conditions, Investment Profile, Internal Conflict, External Conflict, Corruption, Military in Politics, Religion in Politics, Law and Order, Ethnic Tensions, Democratic Accountability, and Bureaucracy Quality. The financial risk components include: Foreign Debt as a Percentage of GDP, Foreign Debt Service as a Percentage of Exports of Goods and Services, Current Account as a Percentage of Exports of Goods and Services, Net International Liquidity as Months of Import Cover, and Exchange Rate Stability. The Economic Risk category includes: Per Capita GDP, Real GDP Growth, Annual Inflation Rate, Budget Balance as a Percentage of GDP, and Current Account as a Percentage of GDP. First, I explore whether any of these measures contain information about future expected stock returns by conducting trading simulations. Second, I show the relation between these measures and implied costs of capital based on earnings forecasts. My results suggest that the country risk measures are correlated future equity returns - but only in emerging markets. These results are consistent with emerging markets being to some degree segmented from world capital markets.

Keywords: Political Risk, Quality of Institutions, Law and Order, Financial Risk, Economic Risk, Country Risk Premium, Market Integration, Market Segmentation, Implied Cost of Capital

JEL Classification: F30, F36, G15, G12

Suggested Citation

Harvey, Campbell R., Country Risk Components, the Cost of Capital, and Returns in Emerging Markets. Available at SSRN: https://ssrn.com/abstract=620710 or http://dx.doi.org/10.2139/ssrn.620710

Campbell R. Harvey (Contact Author)

Duke University - Fuqua School of Business ( email )

Box 90120
Durham, NC 27708-0120
United States
919-660-7768 (Phone)
919-660-8030 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Duke Innovation & Entrepreneurship Initiative ( email )

215 Morris St., Suite 300
Durham, NC 27701
United States

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