An overview of the current literature on the explanatory power of risk indices, their impact, and their usefulness in emerging markets.
This paper attempts to show, how given the present increase in world risk, the explanatory power of risk indices is of increasing importance. It looks at how the divergence findings of Hooper and Heaney (1999), Erb and Harvey (1996), and Cosset and Suret (1995) on market segmentation and mean reversion warrant investigation. It discusses how all three papers are thorough and exhaustive and still exhibit limitations in sample space, or their chosen time analysis. It also investigates the effect of financial risk on emerging market volatility and returns.
“Mean reversion is a fundamental aspect of country risk. Erb and Harvey (1996) investigate the impact of mean reversion on financial markets. Their findings indicate a prominence of mean reversion in political indicators; however, find that evidence of mean reversion decreases in credit measures. This is likely due to the stabilizing influence of multinational corporations, as indicated by Heaney and Hooper (2002). Hooper and Heaney (1999) allude to this influence when commenting that there was little structural change over the period despite the observed volatility. On the other hand, Perotti and Oijen (1999) propose the that mean reversion can be circumvented by a market friendly government changing a country’s institutional fundamentals. Nonetheless, there is largely a consensus, given no major structural shift, of the undeniable role of mean reversion in emerging markets.”