Toward a market sector-based composite political risk indicator model

Abstract

Model risk involves the risk of model misspecification. In this chapter it is argued that unsystematic risk is an indicator of country-specific and human factors. With a strong theoretical base for a systematic capital asset pricing model specification, these factors may be classified as political risk, which is influenced by social, legal, and cultural effects. When adjusted for degrees of systemic information efficiency and country-industry interaction with global stock markets, this uncomplicated analytical tool could reduce model risk and be used to calculate composite political risk, which can be used as an adjunct to other risk indicators. Government and industry risk analysts may be able to preempt market and political risk problems and to price risk premia in international bank lending with greater frequency of information than is currently available. The example used in study involves a hypothetical country banking industry and its interaction with the global banking industry. Future research will test the model's efficacy.