Emerging Markets : Stock Market Investing with Political Risk

Besides market risk, stock market investments in emerging markets are also exposed to political phenomena that are not generally present in the more developed economies. This problem is well known to banks and multinational companies as country or political risk. Assessment techniques in these domains are relatively well developed but unadapted to portfolio investment in that they tend to ignore the diversification aspect associated with cross country correlations. In this paper we address the problem of political risk with cross country correlations. We develop a model for simultaneously measuring the cost of political risk in several countries that retains most of the characteristics of the single country risk model in terms of its ability to price political risk based on the stochastic process of exposure to loss and the expected frequency of loss causing events. It generalizes the one company-one country approach, however, in that a multivariate approach is taken and correlations across countries are considered directly. The technique developed here can be implemented into a decision support program, providing a feasible solution to the ongoing difficulty of apprehending the multivariate nature of political risk and integrating it into the process of portfolio management