Sensitivity of Equity Returns to Political Risk Premiums

In this paper we study the impact that political risk premiums have on market index returns in thirty-one countries. We also include the impact of exchange rates and inflation rates. Fifteen of the countries are classified as developing, and sixteen of them are classified as developed based on the World Bank classifications. These classifications play a role in the analysis as they are included as a dummy variable in the cross-sectional time-series regressions we run in order to analyze the sensitivities. We use a spread between interest yields on sovereign bonds and a comparable U.S. bond as a proxy for the political risk premium. We find evidence that market index returns are negatively affected by political risk premiums. The results suggest that political instability in countries negatively affects the returns of companies found on the local financial markets. These results suggest that consideration of political risks is an important part of foreign investment decision-making