Political Risk Spreads

We introduce a new, market-based and forward looking measure of political risk derived from sovereign yield spreads. Our political risk spread extracts the part of the sovereign spread that is due to political risk, making use of political risk ratings. We provide new evidence that these political risk ratings are predictive, on average, of future risk realizations. In using our measure to account for political risk in evaluations of international investments, it does not double count systematic risk as some conventional measures do. We show that a one percent reduction in the political risk spread is associated with a 10 percent increase in net-inflows of foreign direct investment.

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