The effect of political risk on emerging and developed markets

This thesis consists of three substantive chapters (3, 4, 5) on the impact of political risk on equity and exchange rate returns and their volatilities.  Chapter 3 proposes a framework for predicting market returns and volatility using changes in the country’s political risk. We identify the appropriate lag to to calculate changes over, and how the changes should be included in mean and volatility equations. The level of aggregation of political risk variable is also examined. Analysing 47 emerging and 21 developed markets, we find predictive power primarily for volatility of emerging markets, and recommended use of three political risk components which suitably capture important dimensions of political environment.  In the Chapter 4 we empirically examines the impact of political risk on returns and volatility of individual firms and industry portfolios from New Zealand and Pakistan. The data used in the study consist of 184 firms from New Zealand and 202 firms from Pakistan along with country-level political risk data from the ICRG. As in the , we find in Chapter 3 that the impact of political risk is more on volatility than the returns of firms in both markets. As we expect, the impact of political risk is more on Pakistani firms compared to those in New Zealand. Overall, results from the industry portfolios are according to the hypothesis that political risk impact is different across industries (volatility increase for some industries and decrease for few).  Chapter 5 examine the relationship between political risk variables on the nominal exchange rate return and its volatility. We again investigate developed versus developed markets, and also consider three different exchange rate regimes i.e. floating, managed floating and fixed. This is important to examine the link between political risk and exchange rate because there are two sources of political risk one on either side of the exchange rate. In our analysis, we use the political risk spread between the country of interest and the USA. Overall results reveal that emerging markets are more exposed to political risk compared to developed. Further, the impact of political risk variables is more on the floating exchange rate compared to managed floating and fixed exchange rate as might be expected, since intervention in the market will generally reduce to eliminate the influence of alternative factors. We also find strong evidence that volatility increases more during a period of high political risk and poor economic conditions for emerging markets.