Political Risk

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Political Risk, Economic Risk and Financial Risk
Claude B. Erb
First Chicago Investment Management Co., Chicago, IL 60670

Campbell R. Harvey
Duke University, Durham, NC 27708 National Bureau of Economic Research, Cambridge, MA 02138

Tadas E. Viskanta
First Chicago Investment Management Co., Chicago, IL 60670

1 Erb-Harvey-Viskanta--Political Risk, Economic Risk and Financial Risk: May 6, 1996.

Political Risk, Economic Risk and Financial Risk

ABSTRACT

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’s political, financial, economic and composite risk indices and Institutional Investor’s country credit ratings. We explore whether any of these measures contain information about future expected stock returns. Next, we conduct time-series-crosssectional analysis linking these risk measures to future expected returns. Finally, we analyze the linkages between fundamental attributes within each economy, such as bookto-price ratios, and the risk measures. Our results suggest that the country risk measures are correlated future equity returns. In addition, country risk measures are highly correlated with equity valuation measures. This provides some insight into the reasonwhy valueoriented strategies generate high average returns.

2 Erb-Harvey-Viskanta--Political Risk, Economic Risk and Financial Risk: May 6, 1996.

Political Risk, Economic Risk and Financial Risk

SHORT ABSTRACT

We assess the economic importance of political, economic and financial measures of country risk. While the country risk measures contain unique information, they are highly correlated with equity valuation measures, such as price-to-book ratios. This helps explain why value-oriented strategies generate high average returns.

3 Erb-Harvey-Viskanta--Political Risk, Economic Risk and Financial Risk: May 6, 1996.

1. Introduction

What is country risk and how should it impact global investment strategies? We explore the information in five different measures of country risk. The first four measures are from Political Risk Services’ International Country Risk Guide (ICRG). These measures include political risk, economic risk and financial risk. The ICRG also reports a measure of composite risk which is a simple function of the three base indices. The final measure we examine is Institutional Investor’s country credit ratings. We define the information content in a number of different ways.

We initially explore whether the risk indices contain information about future expected returns.1 This analysis is conducted in two ways. First, we form a portfolio of countries which experience a decrease in the risk rating (become more risky) and a portfolio of countries which experience an increase in the risk rating (become less risky). We form the portfolio after the risk information is available and rebalance the portfolio every six months. We find that there is, indeed, information about expected equity returns in these measures. We supplement this analysis with a time-series cross-sectional regressions which measure the amount of information contained in each metric. We find that the financial risk measure contains the most information about future expected returns and political risk contains the least.

The next part of our analysis investigates the link between these country risk measures and some more standard measures of risk. We investigate whether there is a correlation

To ensure the widest possible dissemination of our methodology, we have established a country risk homepage: http://www.duke.edu/~charvey/Country_risk/couindex.htm This site includes information on 135 different countries which could not be included in this manuscript. For example, the site contains equity return...
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