Political Risk, Economic Risk and Financial Risk
Claude B. Erb
Campbell R. Harvey
Duke University - Fuqua School of Business; National Bureau of Economic Research (NBER); Duke Innovation & Entrepreneurship Initiative
Tadas E. Viskanta
First Chicago Investment Management Co.
May 6, 1996
Fuqua School of Business Working Paper No. 9606
How important is an understanding of country risk for investors? Given the increasingly global nature of investment portfolios, we believe it is very important. Our paper measures the economic content of five different measures of country risk: The International Country Risk Guide is political risk, the financial risk, economic risk and composite risk indices and Institutional Investoris country credit ratings. First, we explore whether any of these measures contain information about future expected stock returns by conducting trading simulations. Next, we conduct time-series-cross-sectional analysis linking these risk measures to future expected returns. Second, we investigate the relation between these measures and other, more standard, approaches to risk exposures. Finally, we analyze the linkages between fundamental attributes within each economy, such as book-to-price ratios, and the risk measures. Our results suggest that the country risk measures are correlated future equity returns. We find that the country risk measures are correlated with each other, however, financial risk measures contain the most information about future equity returns. Finally, we find that country risk measures are highly correlated with country equity valuation measures. This provides some insight into the reason why value-oriented strategies generate higher returns.
Number of Pages in PDF File: 41
Keywords: Country Risk Assessment, Mean-Reverision of Risk, Country Trading Strategies, Risk Exposure
JEL Classification: F30, F36, G12, G15
Date posted: May 8, 2000