IS POLICY RISK PRICED IN INTERNATIONAL EQUITY MARKETS?

Abstract

This study finds that policy risk is priced in international equity markets. A study of 49 countries suggests that policy risk explains the intertemporal variation of country returns.I develop a five-factor model that allows for the pricing of policy risk. The five factors are the excess returns on a world market portfolio, the world value factor, exchange rate risk factor, bureaucracy quality factor and government stability factor. Together, the five factors are robust and outperform common international asset pricing models like the international CAPM and international Fama and French three-factor models. I extend the policy risk literature by developing insights into policy risk. My analysis finds that perceived government reputation and credibility and the strength of bureaucratic machinery play important and orthogonal roles in influencing the overall level of policy risk in the country. Government reputation and credibility refers to the track record of a government in making sound policy decisions and developing the country’s economy. Hence, better government reputation and credibility leads to lower policy risk in a country. On the other hand, bureaucratic strength is determined by the expertise of a bureaucracy in absorbing shocks in policy changes, and the autonomy of the bureaucracy from frequent government intervention. When bureaucratic institutions in a country are strong, the chances of the country being subject to policy reversals at the whims of its government are lower. Between the two factors, I find that the bureaucracy quality factor is the dominant factor in determining policy risk.