Skip to main content
SpringerLink
Log in

Political risk spreads

  • Article
  • Published:
Journal of International Business Studies Aims and scope Submit manuscript

Abstract

We introduce a new, market-based and forward-looking measure of political risk derived from the yield spread between a country’s US dollar debt and an equivalent US Treasury bond. We explain the variation in these sovereign spreads with four factors: global economic conditions, country-specific economic factors, liquidity of the country’s bond, and political risk. We then extract the part of the sovereign spread that is due to political risk, making use of political risk ratings. In addition, we provide new evidence that these political risk ratings are predictive, on average, of future risk realizations using data on political risk claims as well as a novel textual-based database of risk realizations. Our political risk spread measure does not make the mistake of double counting systematic risk in the evaluation of international investments, as some conventional measures do. Furthermore, we show how to construct political risk spreads for countries that do not have sovereign bond data. Finally, we link our political risk spreads to foreign direct investment (FDI). We show that a 1% point reduction in the political risk spreads is associated with a 12% increase in net-inflows of FDI.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Figure 1
Figure 2
Figure 3

Similar content being viewed by others

Notes

  1. Graham and Harvey (2001) show that for a large sample of US firms the overwhelming majority use a net present value rule for evaluating investment and about 75% use the CAPM as an input for the discount rate. However, Holmen and Pramborg (2009), surveying the capital budgeting techniques for FDI among Swedish firms, show that firms are less likely to use theoretically correct NPV approaches for investments in host countries with elevated political risk.

  2. Lessard (1996) and Bekaert and Hodrick (2011, Chapter 14) argue that in theory political risk should be incorporated into cash flows. Butler and Joaquin (1998) also discuss the choice of incorporating political risk into project cash flows or the discount rate.

  3. Let CF t be the expected cash flows at time t and R t the Recovery value of the MNC’s project in the face of a political risk event at time t. Then the present value of the project is

    That is, we assume political risk probabilities and discount rates to be constant over time (as in our simple example). As long as R t is 0, the relationship in Equation (4) between political risk spreads and p continues to hold. If R t is non-zero, Eq. (6) can be used to infer the correct political risk probability.

  4. The use of sovereign spreads is widespread among consultants, for an overview, see Harvey (2001). Morningstar, a leading vendor of cost of capital estimates in the United States, provides two estimates involving sovereign spreads. Finally, the major international financial management textbooks such as Shapiro (2009) and Bekaert and Hodrick (2011) also mention the practice.

  5. See http://faculty.fuqua.duke.edu/~charvey/PRS/ for the Internet Appendices.

  6. Yet Tomz and Wright (2007), using data for the period 1820–2004, find only weak correlation between economic output in the borrowing country and sovereign defaults. Nevertheless, in the Online Appendix A, we report the pooled correlation of the political risk rating and its subcomponents with our economic rating. The correlations are as low as 0.162 for Religious Tensions and as high as 0.752 for Investment Profile. As the overall political rating is almost 70% correlated with economic risk, it may not be surprising that authors such as Perotti and van Oijen (2001) and Click and Weiner (2010) use the Institutional Investor country risk ratings as a proxy for political risk.

  7. OPIC data exist from 1970 and represent nearly 300 claims. There is some earlier data from 1966 when political risk insurance was administered by the Agency for International Development (USAID). Claims data are available from 1996 at http://www.opic.gov/what-we-offer/political-risk-insurance/claims-determinations.

  8. Nel’s (2007) dissertation follows a similar method to Howell and Chaddick (1994) and reports correlations between 14 countries’ losses and various ratings (14 observations).

  9. For a similar approach see Baker, Bloom, and Davis (2013), as well as Brogaard and Detzel (2012).

  10. Group-wise heteroskedasticity means that each diagonal element of the variance–covariance matrix is unique – each country error has its own variance level. SUR accommodates contemporaneously correlated errors across countries.

  11. The Chicago Board Options Exchange VIX measures the implied volatility of S&P 500 index options. This index is often viewed as an indicator of global risk aversion, but also reflects US stock market volatility.

  12. In our empirical work, we found that using the two ratings separately did not improve the empirical fit, and that both ratings received statistically similar coefficients.

  13. For a subset of countries, we also collect data on 5-year sovereign debt CDS contracts from Markit and run a similar panel model. The results are qualitatively analogous to the results for our main model.

  14. We also estimated a version of Table 3 using the logarithm of the sovereign spread as the dependent variable. The results are similar and are available on request.

  15. Online Appendix E presents the same analysis for South Africa.

  16. This probability is 1−(1−p)10.

  17. The Table 7 regressions have a generated regressor when we use the political risk spread. To address this potential problem, we conducted the following simulation experiment. We draw 1000 alternative first stage parameters from their asymptotic normal distribution (i.e., using the existing point estimates as the mean and the estimated variance–covariance matrix as the variance). We then use these to create annual PRS data for all the countries we use in the second stage. Finally, we rerun our FDI regressions in Table 7 1000 times and store the coefficient values and t-statistics on the extracted PRS and the residual. These estimates, under the alternative, taking our set-up as a starting point, should be centered around our existing point estimates of the coefficients and t-statistics and they are. For example, the t-statistics on the political risk spread is −2.46 in Table 7. The 10th and 90th percentiles of the distribution are −2.52 and −2.27. Hence, we conclude that the generated regressor problem is not interfering with our inference.

References

  • Alfaro, L., Kalemli-Ozcan, S., & Volosovych, V. 2008. Why doesn’t capital flow from rich to poor countries? An empirical investigation. Review of Economics and Statistics, 90 (2): 347–368.

    Article  Google Scholar 

  • Andersen, T. G., Bollerslev, T., Diebold, F. X., & Labys, P. 2003. Modeling and forecasting realized volatility. Econometrica, 71 (2): 579–625.

    Article  Google Scholar 

  • Anshuman, V. R., Martin, J. D., & Titman, S. 2011. Sovereign risk and investing in emerging markets. Journal of Applied Corporate Finance, 23 (2): 41–49.

    Article  Google Scholar 

  • Baker, S., Bloom, N., & Davis, S. 2013. Measuring economic policy uncertainty, Working Paper, Stanford University, Stanford, CA.

  • Bekaert, G., Harvey, C. R., & Lundblad, C. 2005. Does financial liberalization spur growth? Journal of Financial Economics, 77 (1): 3–55.

    Article  Google Scholar 

  • Bekaert, G., & Hodrick, R. J. 2011. International financial management, 2nd edn. Upper Saddle River, NJ: Prentice Hall.

    Google Scholar 

  • Borensztein, E., De Gregorio, J., & Lee, J.-W. 1998. How does foreign direct investment affect growth? Journal of International Economics, 45 (1): 115–135.

    Article  Google Scholar 

  • Bremmer, I. 2005. Managing risk in an unstable world. Harvard Business Review, 83 (6): 51–58.

    Google Scholar 

  • Brewer, T. L. 1983. The instability of governments and the instability of controls on funds transfers by multinational enterprises: Implications for political risk analysis. Journal of International Business Studies, 14 (3): 147–157.

    Article  Google Scholar 

  • Brewer, T. L. 1993. Government policies, market imperfections, and foreign direct investment. Journal Journal of International Business Studies, 24 (1): 101–120.

    Article  Google Scholar 

  • Brogaard, J., & Detzel, A. 2012. The asset pricing implications of government economic policy uncertainty, Working Paper, University of Washington, Seattle.

  • Butler, K. C., & Joaquin, D. C. 1998. A note on political risk and the required return on foreign direct investment. Journal of International Business Studies, 29 (3): 599–607.

    Article  Google Scholar 

  • Choi, S. J., Gulati, G. M., & Posner, E. A. 2011. Political risk and sovereign debt contracts, Working Paper no. 370, University of Chicago Public Law, Chicago, IL.

  • Citron, J.-T., & Nickelsburg, G. 1987. Country risk and political instability. Journal of Development Economics, 25 (2): 385–392.

    Article  Google Scholar 

  • Click, R. W. 2005. Financial and political risks in US direct foreign investment. Journal of International Business Studies, 36 (5): 559–575.

    Article  Google Scholar 

  • Click, R. W., & Weiner, R. J. 2010. Resource nationalism meets the market: Political risk and the value of petroleum reserves. Journal of International Business Studies, 41 (5): 783–803.

    Article  Google Scholar 

  • Cosset, J.-C., & Roy, J. 1991. The determinants of country risk. Journal of International Business Studies, 22 (1): 135–142.

    Article  Google Scholar 

  • Damodaran, A. 1999. Estimating Equity Risk Premiums, Working Paper FIN-99-021, New York University, New York.

  • Demirbag, M., Glaister, K. W., & Tatoglu, E. 2007. Institutional and transaction cost influences on MNEs’ ownership strategies of their affiliates: Evidence from an emerging market. Journal of World Business, 42 (4): 418–434.

    Article  Google Scholar 

  • Edwards, S. 1984. LDC foreign borrowing and default risk: An empirical investigation, 1976–1980. American Economic Review, 74 (4): 726–734.

    Google Scholar 

  • Feinberg, S. E., & Gupta, A. K. 2009. MNC subsidiaries and country risk: Internalization as a safeguard against weak external institutions. Academy of Management Journal, 52 (2): 381–399.

    Article  Google Scholar 

  • Globerman, S., & Shapiro, D. 2003. Governance infrastructure and US foreign direct investment. Journal of International Business Studies, 34 (1): 19–39.

    Article  Google Scholar 

  • Graham, J. R., & Harvey, C. R. 2001. The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60 (2–3): 187–243.

    Article  Google Scholar 

  • Habib, M., & Zurawicki, L. 2002. Corruption and foreign direct investment. Journal of International Business Studies, 33 (2): 291–307.

    Article  Google Scholar 

  • Harvey, C. R. 2001. The International Cost of Capital and Risk Calculator (ICCRC), Working Paper, Duke University, Durham.

  • Henisz, W. J. 2003. The power of the Buckley and Casson thesis: The ability to manage institutional idiosyncrasies. Journal of International Business Studies, 34 (2): 173–184.

    Article  Google Scholar 

  • Henisz, W. J., & Delios, A. 2001. Uncertainty, imitation, and plant location: Japanese multinational corporations, 1990–1996. Administrative Science Quarterly, 46 (3): 443–475.

    Article  Google Scholar 

  • Henisz, W. J., & Zelner, B. A. 2010. The hidden risks in emerging markets. Harvard Business Review, 88 (4): 88–95.

    Google Scholar 

  • Holmen, M., & Pramborg, B. 2009. Capital budgeting and political risk: Empirical evidence. Journal of International Financial Management and Accounting, 20 (2): 105–134.

    Article  Google Scholar 

  • Howell, L. D., & Chaddick, B. 1994. Models of political risk for foreign investment and trade: An assessment of three approaches. Columbia Journal of World Business, 29 (3): 70–91.

    Article  Google Scholar 

  • Kanto, M., Nolan, M. D., & Sauvant, K. P. 2011. Reports of Overseas Private Investment Corporation Determinations, Vol. 1–2 New York: Oxford University Press.

    Google Scholar 

  • Knudsen, H. 1974. Explaining the national propensity to expropriate: An ecological approach. Journal of International Business Studies, 5 (1): 51–71 86–89.

    Article  Google Scholar 

  • Kobrin, S. J. 1979. Political risks: A review and reconsideration. Journal of International Business Studies, 10 (1): 67–80.

    Article  Google Scholar 

  • Lesmond, D. 2005. Liquidity of emerging markets. Journal of Financial Economics, 77 (2): 411–452.

    Article  Google Scholar 

  • Lessard, D.R. 1996. Incorporating country risk in the valuation of offshore projects. Journal of Applied Corporate Finance, 9 (3): 52–63.

    Article  Google Scholar 

  • Li, Q., & Resnick, A. 2003. Reversal of fortunes: Democratic institutions and foreign direct investment inflows to developing countries. International Organization, 57 (1): 175–211.

    Article  Google Scholar 

  • Longstaff, F., Pan, J., Pedersen, L., & Singleton, K. J. 2011. How sovereign is sovereign credit risk? American Economic Journal-Macroeconomics, 3 (2): 75–103.

    Article  Google Scholar 

  • Loree, D. W., & Guisinger, S. E. 1995. Policy and non-policy determinants of US equity foreign direct investment. Journal of International Business Studies, 26 (2): 281–299.

    Article  Google Scholar 

  • Mariscal, J. O., & Lee, R. M. 1993. The valuation of mexican stocks: An extension of the capital asset pricing model to emerging markets. New York: Goldman Sachs.

    Google Scholar 

  • Minor, M. S. 1994. The demise of expropriation as an instrument of LDC policy, 1980–1992. Journal of International Business Studies, 25 (1): 177–188.

    Article  Google Scholar 

  • Nel, D. 2007. Revisiting three political risk forecast models: An empirical test. PhD thesis, University of Johannesburg.

  • Neumayer, E., & Spess, L. 2005. Do bilateral investment treaties increase foreign direct investment to developing countries? World Development, 33 (10): 1567–1585.

    Article  Google Scholar 

  • Newey, W. K., & West, K. D. 1987. A simple, positive semi-definite, heteroskedasticity and autocorrelation consistent covariance matrix. Econometrica, 55 (3): 703–708.

    Article  Google Scholar 

  • Nigh, D. 1985. The effect of political events on United States direct foreign investment: A pooled time-series cross-sectional analysis. Journal of International Business Studies, 16 (1): 1–17.

    Article  Google Scholar 

  • Oetzel, J. M., Bettis, R. A., & Zenner, M. 2001. Country risk measures: How risky are they? Journal of World Business, 36 (2): 128–145.

    Article  Google Scholar 

  • Perotti, E. C., & van Oijen, P. H. 2001. Privatization, political risk and stock market development in emerging economies. Journal of International Money and Finance, 20 (1): 43–69.

    Article  Google Scholar 

  • Quinn, D. P., & Toyoda, A. M. 2008. Does capital account liberalization lead to economic growth? Review of Financial Studies, 21 (3): 1403–1449.

    Article  Google Scholar 

  • Sethi, D., Guisinger, S. E., Phelan, S. E., & Berg, D. M. 2003. Trends in foreign direct investment flows: A theoretical and empirical analysis. Journal of International Business Studies, 34 (4): 315–326.

    Article  Google Scholar 

  • Shapiro, A. C. 2009. Multinational financial management, 9th edn. Hoboken, NJ: John Wiley & Sons.

    Google Scholar 

  • Sharpe, W. F. 1964. Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance, 19 (3): 425–442.

    Google Scholar 

  • Tomz, M., & Wright, M. L. J. 2007. Do countries default in “bad times”? Journal of the European Economic Association, 5 (2/3): 352–360.

    Article  Google Scholar 

  • Uhlenbruck, K., Rodriguez, P., Doh, J., & Eden, L. 2006. The impact of corruption on entry strategy: Evidence from telecommunication projects in emerging economies. Organization Science, 17 (3): 402–414.

    Article  Google Scholar 

  • UNCTAD. 2010. World Investment Report 2010. Investing in a low-carbon economy, New York and Geneva.

  • Vaaler, P. M., Schrage, B. N., & Block, S. A. 2005. Counting the investor vote: Political business cycle effects on sovereign bond spreads in developing countries. Journal of International Business Studies, 36 (1): 62–88.

    Article  Google Scholar 

  • Wei, S.-J. 2000. How taxing is corruption on international investors? Review of Economics and Statistics, 82 (1): 1–11.

    Article  Google Scholar 

Download references

Acknowledgements

This paper has benefitted from the comments of David Reeb and two anonymous referees. We benefitted from the comments of seminar participants at the AFA 2013 meetings, the 2012 Pacific Northwest Finance Conference, Banco Central de Reserva del Perú, Indian School of Business, Case Western Reserve University, Erasmus University, and the University of Virginia. We thank Jonathan Brogaard for sharing computer code to search global news. Siegel acknowledges the financial support from the Global Business Center at the University of Washington. Bekaert acknowledges financial support from Netspar. We appreciate the research assistance of Nicholas Alphin, Zeca Cardoso, Catriona Harvey, Thompson Teagle, Samuel Towne, and Eduardo Vanegas-Garcia.

Author information

Authors and Affiliations

  1. Columbia University, New York, USA

    Geert Bekaert

  2. National Bureau of Economic Research, Cambridge, USA

    Geert Bekaert & Campbell R Harvey

  3. Duke University, Durham, USA

    Campbell R Harvey

  4. University of North Carolina, Chapel Hill, USA

    Christian T Lundblad

  5. University of Washington, Seattle, USA

    Stephan Siegel

Authors
  1. Geert Bekaert
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Campbell R Harvey
    View author publications

    You can also search for this author in PubMed Google Scholar

  3. Christian T Lundblad
    View author publications

    You can also search for this author in PubMed Google Scholar

  4. Stephan Siegel
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Campbell R Harvey.

Additional information

Accepted by David Reeb, Area Editor, 7 January 2014. This paper has been with the authors for four revisions.

Rights and permissions

Reprints and permissions

About this article

Check for updates. Verify currency and authenticity via CrossMark

Cite this article

Bekaert, G., Harvey, C., Lundblad, C. et al. Political risk spreads. J Int Bus Stud 45, 471–493 (2014). https://doi.org/10.1057/jibs.2014.4

Download citation

  • Received:

  • Revised:

  • Accepted:

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1057/jibs.2014.4

Keywords

Search

Navigation