Dynamics of Political Risk Rating and Stock Market Volatility

Abstract

In this paper we propose a framework for predicting market returns and volatility using changes in the country's political risk. We identify the appropriate lag to calculate changes over, and show how the changes should be included in mean and volatility equations. The appropriate level of aggregation for the political risk variable is also examined. We analyse 47 emerging and 21 developed markets. We find political risk predictive power primarily for volatility, when looking at emerging markets. Our paper recommends use of three political risk components, which suitably capture important dimensions of the political environment.