Political Risk, Economic Risk, and Financial Risk

Given the increasingly global nature of investment portfolios, an understanding of country risk is very important. This article addresses the economic content of five different measures of country risk: four measures from the International Country Risk Guide's political-, financial-, economic-, and composite-risk indexes and one from Institutional Investor's country credit ratings. We explored whether any of these measures contain information about future expected stock returns. We conducted time-series/cross-sectional analysis linking these risk measures to future expected returns. Finally, we analyzed the links between fundamental attributes such as book-to-price ratios within each economy and the risk measures. The results suggest that the country-risk measures are correlated with future equity returns. In addition, such measures are highly correlated with equity valuation measures. This finding provides some insight into the reason that value-oriented strategies generate high average returns.