Are Markets Efficient with Respect to Political Risks: Evaluating the Political Risk Sign Paradox Using Logit Panel Data

Spurred by the political risk sign paradox and the atheoretical findings that returns do not adhere to expected relationships when political risk ratings change, this study contributes to the understanding of causes of market inefficiency and, specifically, to the information content of inefficient markets. The study examines the relationship between political risk scores and the log odds of market inefficiency for 44 developing stock markets using data from 2008 through 2022. Using a logit model with random effects and robust standard errors, stationary time series data, and no serial correlation indicates that aggregate political risk has a moderately significant relationship (p-value is 6%) with weak-form market inefficiency by year. Conversely, countries with less political risk have lower odds of having inefficient stock markets. The relationship between subclassifications of political risk and market inefficiency is only significant for internal conflict and social problems. Partial panels that evaluate the significance of institutional membership, income level, region, and a history of colonization produce conflicting results regarding the significance of aggregate political risk. Political risk is significant at the 5% level for the models that include Asia, Latin America, the Middle East, and upper middle-income countries and at the 10% level for the model that includes an indicator variable for Africa. Political risk is not significant for the EU, NATO, Europe, colonized countries, and high or lower middle-income markets. The study also shows that lagged values of political risk are not associated with inefficiency, but there may be some non-linearity to the relationship. The study finds that frontier markets have higher odds of inefficiency, as do countries that were formerly colonies. However, as returns increase, the odds of inefficiency decrease, regardless of whether political risk is significant. All this evidence indicates the relationship between political risk and market inefficiency depends on a number of conditions, as suggested by the Adaptive Markets Hypothesis.