Impact of political risk on emerging market risk premiums and risk adjusted returns

Abstract

Researchers have observed the political risk, sign paradox whereby a decrease in political risk is associated with an increase in stock market returns. This apparent contradiction may be driven by a few political risk factors or perhaps certain emerging market (EM) countries. This paper examines this issue by assessing how key political risk components impact equity risk premiums and risk adjusted returns among EM countries. Using monthly stock market return data for 28 EM countries from 2000 to 2019, we segment countries into high and low political risk groups to explore heterogeneous effects. We find that improvements in political risk increase risk adjusted returns by lowering the volatility of returns. Differences were also found between EM countries with improvements in government stability leading to higher risk adjusted returns among high political risk EM countries. In contrast for low political risk countries, democracy was found to have a negative effect on equity premiums, while law and order and investment profile have a positive impact. Finally, our results suggest key political risk subcomponents, such as investment profile and corruption, impact risk adjusted returns during times of financial crisis.