Political Risk and The Cost of Capital in The MENA Region

Political risk and the cost of capital in the MENA region
Mohamed Belkhir
College of Business and Economics, UAE University
United Arab Emirates
m.belkhir@uaeu.ac.ae
Narjess Boubakri
School of Business and Management, American University of Sharjah
nboubakri@aus.edu
Jocelyn Grira
College of Business and Economics, UAE University
jocelyn.grira@uaeu.ac.ae
Forthcoming, Emerging Markets Review

August 2017
ABSTRACT
We examine the impact of political risk in the MENA region on the cost at which
firms can raise capital. Using the implied cost of equity as a measure of the cost of
capital and ICRG’s political risk rating as a proxy for political risk, we find that
political risk results in a higher cost of capital. Economically, our results suggest
that a one standard deviation increase in the political risk index is associated with
a 450 basis points increase in the cost of equity capital of MENA firms. Our results
are consistent across a battery of robustness checks. Our findings have important
policy implications that are relevant to the MENA region and beyond.
Key words: Political risk, Institutions, cost of capital, MENA, investment.

JEL Classification: G11, G32, G38.
Electronic copy available at: https://ssrn.com/abstract=3027987

1. Introduction
The Middle East and North Africa region (MENA hereafter) has been in political turmoil for
almost a century now – since the fall of the Ottoman Empire. In particular, the region has been
fractured along various fault lines, including sectarian, ethnic, tribal, and more recently socio-
economic ones. Such sectarian, ethnic, and tribal divisions have led in many instances to civil
wars that lasted many years and resulted in uncounted numbers of casualties and displaced
people. Examples include the Lebanese 1975-1990 civil war, the Sudanese 1983-2005 civil war,
and the ongoing civil wars in Iraq, Libya, Syria, and Yemen. Other countries not directly at
war are usually hurt by spillovers from wars surrounding them. They are typically prone to
security tensions due to possible revenge and terrorist attacks. Further, until recently, most of
the region’s countries had been ruled by authoritarian regimes lacking the popular legitimacy
that can fend them off against military coups and general public discontent and dissidence.
Such regimes’ lack of legitimacy has always been a threat to political stability in the region. In
sum, the region is fraught with severe tensions and the recent uprisings – Arab spring – only
brought to the surface and to the forefront of media and public attention an old problem laying
at the heart of the region’s grievances – political risk.
Against this backdrop, many MENA countries suffer from a dearth of investment, especially
private investment, poor economic development and high unemployment rates.1 Investment
theory based on the net present value (NPV) rule suggests that an investment is undertaken
if the discounted value of its estimated future cash flows exceeds its initial outlay.
Accordingly, the lack of firm investment in the MENA region can be due either to low
forecasted future cash flows or to high discount rates, which reflect the firm’s cost of capital.
In this study, we focus on the second effect – the cost of capital effect, and we conjecture that
political risk has a significant influence on firm cost of equity capital in MENA countries.
Examining the link between political risk and the cost of equity capital adds to (i) the literature
on the political determinants of firm level outcomes, (ii) allows to empirically test Pastor and
Veronesi (2013) model showing that political uncertainty 2is priced and commands a risk
1 The average MENA region private investment rate is about 15% of GDP (IMF 2013 estimates).
According to recent IMF and World Bank statistics, unemployment in the MENA region is the highest
in the world –a rate close to 20%, with youth unemployment rate reaching up to 25%; this rate reaches
up to about 30% in Tunisia.
2 The authors define political uncertainty as the uncertainty that derives from government future
actions, that could affect markets, capital availability and hence firms. Relatedly, policy risk is defined
by ICRG as the country’s assessment of twelve political dimensions including conflicts, government
stability, religious tensions, corruption, internal and external conflicts. Perotti (1995) defines political
Electronic copy available at: https://ssrn.com/abstract=3027987

premium whose magnitude is larger in poorer economic conditions; and (iii) contributes to
the understanding of MENA region’s political economy issues by shedding light on the role
of political risk in firms access’ to finance.
We posit that MENA countries’ political risk is non-diversifiable and is thus priced by
investors for several reasons: First, most investors in MENA countries’ stock markets are local
investors with the bulk of their wealth invested in local stocks or in stocks from neighboring
countries (e.g., investors in the Gulf region tend to concentrate their portfolios in stocks from
GCC stock markets).3 For such investors, political risk is clearly non-diversifiable.4 Second,
even to a global investor, MENA country political risk may not be diversifiable since adverse
political events in the region tend to be correlated with sources of political risk elsewhere. For
instance, following the break out of the Arab spring, protests and social unrest that could
threaten political stability were seen in numerous countries, including Spain (indignados’
movement), the United States (Occupy Wall Street), Greece (Syntagma Square), and China
(Jasmine Protests). This attests of the positive correlation between political risk in MENA
countries and in other countries from other parts of the world. Third, because the MENA
region is usually seen as a homogenous cultural, social, and political regional block, an
increase in the likelihood of political instability in any of the region’s countries leads to fear
that instability may reach the major oil producing countries, which drives up global oil prices.5
The increase in oil prices can be a driver of social and political unrest elsewhere – in different
parts of the world – due to its direct impact on oil-importing countries’ fiscal budgets,
subsidies, cost of living, etc.
Our interest in the relation between political risk and the cost of equity capital in the MENA
region is motivated by two main reasons. First, as outlined above, MENA countries suffer
from a dearth of private investment that is adversely affecting their macroeconomic and social
risk as the uncertainty about government future actions through regulation or policies that could affect
firms’ operations. In this paper, we use both terms interchangeably.
3 GCC (Gulf Cooperation Council) includes six countries: Bahrain, Kuwait, Oman, Qatar, Saudi Arabia,
and United Arab Emirates.

4 For instance, a 2012 Deutsche Bank report finds that only very small volumes of foreign funds are
invested in GCC equity markets. The report is accessible through the following link:
https://www.dbresearch.com/PROD/DBR_INTERNET_EN-
ROD/PROD0000000000296909/GCC+financial+markets%3A+Long-
term+prospects+for+finance+in+the+Gulf+region.pdf (accessed: May 30, 2015).
5 Major events that affect any of the MENA countries tend to have an effect on oil prices. The latest
example is the reaction of the global oil market to the uprisings that took place in 2011 in Tunisia and
Egypt.
2
performance. Studies and surveys contend that access to finance at reasonable terms is a major
hurdle faced by MENA firms in their search for profitable investments. For instance, the most
recent enterprise survey of the World Bank shows that 35.7% of MENA firms identify access
to finance as a major constraint, lagging behind all other regions except Sub-Saharan Africa.6
Moreover, recently, Herrala and Turk-Ariss (2016) assessed the channels through which
political instability influences capital accumulation of MENA firms and find that it is by
substantially reducing firms’ ability to raise credit that political uncertainty negatively affects
capital accumulation. Besides access to credit, political risk can also hinder capital
accumulation through another channel, namely the cost of raising equity capital. This further
motivates us to investigate whether the prevailing political risk in the MENA region affects
the cost at which firms can raise capital. We therefore respond to Herrala and Turk-Ariss’s
(2016; p.14) call to dedicate more research work to the financial channel of political risk as they
state that “the financial channel of political instability deserves more attention in future
research efforts”. Uncovering the effect of political risk on the cost of equity can enlighten
further on the reforms needed to lower MENA firms’ cost of capital and to unlock their power
to invest and create jobs in a region where unemployment rates are amongst the highest in
the world.
Second, the cost of equity is the rate at which expected future cash flows are discounted to
calculate a firm’s stock price. It is therefore of primary importance for firm valuation; firms
with a greater cost of equity capital have a lower equity value. This is of particular interest,
especially for MENA countries whose equity market capitalizations are still lagging behind
despite efforts to enhance frameworks regulating financial markets and investor protection.
In this regard, Roe and Siegel (2011, p.280) state that “Despite efforts to develop finance and
its associated institutions, financial development around the world has been uneven, with
prominent explanations for its variation tied to a nation’s corporate and securities law
institutions, its legal origin, its trade openness, and its legacy of colonial endowments. The
unevenness of financial development provides reason to search for other important determinants of, and
impediments to, financial development beyond those found significant in the past decade.” Roe and
Siegel (2011) identify and document strong empirical evidence that political instability is a key
determinant of a country’s financial under-development. In this study, we intend to add to
this finding by identifying and testing firm cost of equity capital as a potential channel
through which political instability (risk) leads to less developed financial systems; specifically
6 These statistics are available on www.enterprisesurveys.com (accessed on May 12, 2016).
3
equity markets. We also respond to Roe and Siegel’s call to depart from extant literature that
focuses on the role of investor protection in determining countries’ and firms’ decisions and
economic outcomes by considering the role of another country-level factor – political risk
(instability). We focus on the role of political risk in determining firm cost of equity capital.7
To test the impact of political risk on the cost of equity capital in the MENA region, we use a
sample of publicly listed firms from ten countries over the 1997-2012 period or 2,795 firm-year
observations. Following Hail and Leuz (2006), we use a multivariate setting in which the
dependent variable is the average of a firm’s cost of equity generated from four models, which
are the abnormal growth models presented in Easton (2004) and Ohlson and Juettner-Nauroth
(2005) and the residual income valuation models developed by Gebhardt et al. (2001) and
Claus and Thomas (2001). Each of these models derives the ex-ante cost of equity capital
implied by share prices and analysts’ earnings forecasts. Using the International Country Risk
Guide index (ICRG) as a proxy for political risk, we find that a firm’s cost of equity capital
increases in its country’s political risk. This result is robust to various firm- and country-level
controls, alternative measures of political risk, industry, time, and country fixed effects, and
is consistent across various analyses that account for our sample composition. Our results are
also economically significant, with a one standard deviation increase in political risk (ICRG
index) leading to a 4.5% (450 basis points) increase in firms’ cost of equity. We further
investigate the impact of the various dimensions of political risk embedded in ICRG’s
composite index. Using Bekaert et al.’s (2014) decomposition of political risk into four
categories – conflict, institutions, democracy, and government actions –, we find that the risk
of conflict weighs heavily on the cost at which MENA firms raise equity capital. Specifically,
we find that conflict risk has the highest economic impact on the cost of capital among the
four categories of political risk and that it is relevant in both safe and unsafe countries. Risk
related to the quality of institutions is, however, relevant only in safe countries8.
7The common view in the extant empirical finance literature is that firms located in countries with better
legal protection of investors and stronger securities regulations have a lower cost of equity capital (e.g.,
Battacharya and Daouk, 2002; Lambert et al., 2007; Hail and Leuz, 2006; Chen et al., 2009). Countries
that seek to lower their firms’ cost of capital should, thus, implement reforms aimed at strengthening
investor protection.
8
This result complements findings in Hail and Leuz (2006) showing that quality of institutions matters
to the cost of equity (without distinction between safe and unsafe countries). In fact, Hail and Leuz
(2006) show that countries’ legal institutions and securities regulation is systematically related to the
cost of equity capital. In order to capture securities regulation quality, they use (1) an index of disclosure
requirements in securities offerings and (2) another index capturing the strength of securities regulation
mandating and enforcing disclosures, measured as the mean of the disclosure index, the liability
4
Our study‘s central contribution is to provide novel evidence that MENA firms’ cost of capital
is a channel through which political instability and risk can affect firms’ real economic
outcomes. We thus add to the understanding of MENA region’s political economy issues by
shedding light on the role of political risk in deterring firms from raising capital at a moderate
cost, which then translates into low investment and high unemployment rates. Our findings
add to Herrala and Turk-Ariss (2016) results that political instability has a negative impact on
the region’s firms’ access to credit, which in turn hinders capital accumulation, and provide
empirical support for Pastor and Veronesi (2013) model that political uncertainty commands
a risk premium by investors. We show that the region’s political instability also increases
firms’ cost of equity capital.
We also contribute to a literature arguing that political institutions and stability are of primary
importance in explaining financial development. For instance, in contrast to La Porta et al.
(1998) who suggest that legal origin and institutions explain differences in financial
development across countries, Rajan and Zingales (2003) argue that political economy factors
are the most important determinant of a country’s financial development. Roe (2006) further
supports this political view and argues that political economy considerations explain better
than legal origin cross-country differences in financial development. Haber (2005) contends
that political factors were more important than legal factors in developing banking sectors in
Mexico and the U.S. prior to 1913. Additionally, empirical analyses’ findings are in favor of a
prominent role of political institutions (Keefer, 2008) and instability (Roe and Siegel, 2011) in
financial development. We add to this literature by showing that political risk can lead to the
underdevelopment of financial markets, such as is the case in the MENA region, through its
impact on the cost at which firms can raise equity capital.
standard index, and the public enforcement index. Both indices related to securities regulation stem
from La Porta, Lopez-de-Silanes, and Schleifer (2006). Finally, the general quality of the legal
environment is measured as the rule of law index, from La Porta et al. (1997). In our study, we use a
broader index than those used in Hail and Leuz (2006). In fact, we follow Bekaert et al. (2014)’s usage
of ICRG’s composite index as it captures four categories of political – conflicts, institutions, democracy,
and government actions. The two ICRG categories: “conflicts” and “democracy” are not captured by
Hail and Leuz (2006)’s study. However, even though the category “institutions” captures the rule of
law (similar to Hail and Leuz (2006)), it encompasses information about the “bureaucratic quality” and
”corruption”. Finally, “government actions” captures information about government stability,
unemployment, consumer confidence, poverty, contract viability, investors expropriation, profits
repatriation, and payment delays. Hence, “government actions” is also a broader index than those
related to securities regulation and rule of law.
5
Finally, our findings have important policy implications relevant to the MENA region and
beyond. They should add to MENA policy makers’ understanding of the factors that are
causing firm reluctance to invest in spite of various reforms aimed at improving the legal and
business environment. This study should draw the region’s policymakers’ attention that the
creation and enforcement of strong political institutions, which enhance political stability is
one of the primary conditions for the creation of an investment-friendly environment. Further,
we expect this study to be of interest to multilateral financial institutions, such as the World
Bank and the International Monetary Fund. In their policy recommendations aimed at
boosting the region’s economic and social performance, these international organizations tend
to focus exclusively on legal and macroeconomic reforms. The findings of our research show
that a sound political framework that guarantees stability is a prerequisite for any
developmental endeavors.
2. Research design
2.1. Sample
To examine the impact of political risk on the cost of equity financing in the MENA region,
we begin by merging data from four databases: Thompson Institutional Brokers Earnings
Services (I/B/E/S), which provides analyst forecast data, Worldscope, which provides
industry affiliation and financial data, and Datastream, which contains information on stock
prices. We follow Gebhardt et al. (2001) and Dhaliwal et al. (2006) and estimate the cost of
equity in June of each year. To do so, we extract from the I/B/E/S summary file forecast data
recorded in June for all firms that have positive 1- and 2-year-ahead consensus earnings
forecasts and a positive long-term growth forecast. For these firms, we further require that
I/B/E/S provides a share price as of June and that Datastream reports a positive book value
per share. We then follow Hail and Leuz (2006) and Dhaliwal et al. (2006) and estimate the
cost of equity capital using four different models: the Claus and Thomas (2001) model, the
Gebhardt et al. (2001) model, the Ohlson and Juettner-Nauroth (2005) model, and the Easton
(2004) model. These models are discussed in the section below. We take away firm-year
observations for which none of the implied cost of equity estimates converges (Easton, 2004;
Claus and Thomas, 2001; and Gebhardt et al., 2001 models) or is undefined (Ohlson and
Juettner-Nauroth, 2005 model). This procedure yields a final sample of 2,795 year-firm
observations representing 10 MENA countries over the period ranging from 1997 to 2012. We
adopt a broad definition of MENA and select our sample firms from Egypt, Jordan, Kuwait,
6
Lebanon, Morocco, Oman, Saudi Arabia, Tunisia, Turkey, and United Arab Emirates9. We
winsorize all firm-level variables at the 1st and 99th percentiles to avoid the effect of outliers.
Table 1 summarizes the sample composition by country (Panel A), by industry (Panel B), and
by year (Panel C).
2.2. Cost of equity estimates
To study the impact of political risk on firm cost of equity capital in the MENA region, we
follow recent finance literature that advocates the use of the implied cost of capital as a proxy
for ex-ante expected returns (Hail and Leuz, 2006; Dhaliwal et al., 2006; Pastor et al., 2008;
Boubakri et al., 2012; among others).10 The implied cost of capital is the discount rate (r) that
equates the present value of future dividends (Dt + τ) to the current stock price (Pt).

E ( Dt  )
Pt   (1)
 1 (1  r )
To estimate the ex-ante cost of equity capital in MENA countries, we rely on the models of
Ohlson and Juettner-Nauroth (2005, rOJN), Easton (2004, rMPEG), Claus and Thomas (2001, rCT),
and Gebhardt et al. (2001, rGLS) that calculate the cost of equity implied in current stock prices
and analyst earnings’ forecasts. A brief presentation of these models is provided below. To
reduce the dependence of our results on a particular model, we calculate the average of the
cost of equity capital estimates obtained from the four models (RAVG) and use it as our
measure of cost of equity capital.
2.2.1. Claus and Thomas (2001) model
This model builds on the assumption of clean surplus accounting, which allows the current
share price to be a function of the cost of equity, the current book value, forecasted abnormal
earnings, and perpetual abnormal earnings growth. Forecasted abnormal earnings (ae) is
9 Israel is not included in the sample because, even though it is part of the MENA region, it has a much
more advanced and diversified economy that does not face the same problems encountered in the other
MENA region countries, such as less developed financial markets, low investment rates and high
unemployment.
10 Recent literature argues that the ex ante cost of equity implied in stock prices and analysts’ earnings
forecasts is a better measure of cost of capital than ex post returns (e.g., Bekaert and Harvey, 2000; Hail
and Leuz, 2006; Pastor et al., 2008). For instance, according to Pastor et al. (2008, p.2860), “One appealing
feature of the ICC [implied cost of capital] as a proxy for expected returns is that it does not rely on
noisy realized asset returns”.
7
given by forecasted earnings minus a charge for the cost of equity. The horizon for explicit
forecast is five years, after which forecasted residual earnings increase at the expected
inflation rate. We use Hail and Leuz (2006) notation to enunciate the equation for stock
valuation expressed as follows:
𝑇
𝑥̂𝑡+𝜏 −𝑟𝐶𝑇 𝐵𝑡 + 𝜏 − 1 (𝑥̂𝑡+𝑇 −𝑟𝐶𝑇 𝐵𝑡 + 𝑇 − 1 )(1+𝑔)
𝑃𝑡 = 𝐵𝑡 + ∑ + (2)
𝜏=1 (1+𝑟𝐶𝑇 )𝜏 (𝑟𝐶𝑇 −𝑔)(1+𝑟𝐶𝑇 )𝑇
where Pt is the current stock price, Bt is the current book value per share (at the beginning of
year t), 𝑥̂𝑡+𝜏 is the forecasted earnings per share, g is the residual income growth rate that
equals the expected inflation proxied as the annualized median of country-specific one-year-
ahead realized monthly inflation rate, T equals 5 years, and rCT is the cost of equity. Knowing
all the parameters, Eq. (2) is solved numerically for rCT.
2.2.2. Gebhardt et al. (2001) model
This model is also built on the assumption of clean surplus accounting, where the share price
is expressed in terms of the cost of equity, the current book value, and forecasted ROE and
book value. The horizon for explicit forecast is three years, after which forecasted ROE decays
to a target ROE by the 12th year, and remains constant afterward. Following Hail and Leuz
(2006) notation, the model is written as follows:
𝑇
𝑥̂𝑡+𝜏 −𝑟𝐺𝐿𝑆 𝐵𝑡 + 𝜏 − 1 (𝑥̂𝑡+𝑇+1 −𝑟𝐺𝐿𝑆 𝐵𝑡 + 𝑇 )
𝑃𝑡 = 𝐵𝑡 + ∑ (1+𝑟𝐺𝐿𝑆 )𝜏
+ 𝑟𝐺𝐿𝑆 (1+𝑟𝐺𝐿𝑆 )𝑇
(3)
𝜏=1
where Pt is the current stock price, Bt is the current book value per share (at the beginning of
year t), 𝑥̂𝑡+𝜏 is the forecasted earnings per share, T equals 3 years, and rGLS is the cost of equity.
Knowing all the parameters, Eq. (3) is solved numerically for rGLS.
2.2.3. Ohlson and Juettner-Nauroth (2005) model
This model is an extension of the Gordon constant growth model. It expresses share price as
a function of the cost of equity, the one-year-ahead earnings forecast, and near-term and
perpetual growth forecasts. The explicit forecast horizon is assumed to be one year, beyond
which forecast earnings rise at a near-term rate that decays to a perpetual rate. Short-term
earnings growth is the average of the growth rate of forecasted earnings per share from year
t + 1 to year t + 2, and the I/B/E/S long-term growth forecast. The perpetual growth rate
8
equals the expected inflation rate. Using Hail and Leuz (2006) notation, the model is expressed
as follows:
𝑥̂𝑡+1 𝑔 +𝑟 .𝑑̂ /𝑥̂ −𝑔

𝑃𝑡 = ( ) . ( 𝑠𝑡 𝑂𝐽𝑁 𝑡+1 𝑡+1 𝑙𝑡 ) (4)
𝑟𝑂𝐽𝑁 𝑟𝑂𝐽𝑁 −𝑔𝑙𝑡
where Pt is the stock price recorded 10 month after the fiscal year-end, 𝑥̂𝑡+1 is the forecasted
earnings for year t+1, 𝑔𝑠𝑡 is the short-term earnings growth rate, dt is the expected dividend
payout at time t estimated using the average dividend payout over the last three years, glt is
the long-term earnings growth rate and is measured by expected inflation proxied by the
inflation rate in year t+1, and rOJN is the cost of equity capital. Knowing all the parameters, Eq.
(4) is solved analytically (i.e the solution is a closed form expression) for rOJN.
2.2.4. Easton (2004) model
This model builds on the Price–Earnings–Growth (PEG) model. In the model, current share
price is a function of the cost of equity, the expected dividend payout, and one- and two-year-
ahead earnings forecasts. The explicit forecast horizon equals two years, beyond which
forecasted abnormal earnings rise in perpetuity at a constant rate. Easton’s (2004) stock
valuation model is expressed as follows:
𝑥̂𝑡+2 +𝑟𝐸𝑎𝑠𝑡𝑜𝑛 .𝑑̂𝑡+1 −𝑥̂𝑡+1

𝑃𝑡 = 𝑟𝐸𝑎𝑠𝑡𝑜𝑛 2
(5)
where Pt, 𝑥̂𝑡+𝜏 , and dt are defined as in the previous model. Knowing all the parameters, Eq.
(5) is solved numerically for rEaston.
2.3. Political Risk Measures
Our main conjecture in this paper is that investors account for political risk while determining
their expected return rates on investments in stocks of MENA firms. In other words, we
hypothesize that expected political developments influence investors’ required returns on
equity. Hence, to seize this effect, a good proxy for political risk must capture investors’ and
analysts’ ex ante expectations of the extent to which a country can be subject to political
instability rather than ex post political instability. In other words, our political risk proxy
should be forward looking. Further, since our focus is only on political risk rather than on
broad country risk, our political risk measure must single out political risk from other country-
level risks, such as economic and financial risks. We thus use the political risk rating issued
9
by the International Country Risk Guide (ICRG), which is designed to only capture risks that
are political in nature as opposed to economic and financial risks. This rating is widely used
in the financial academic literature as a measure of political risk (e.g., Click and Weiner, 2010;
Bekaert et al., 2014; Lehkonen and Heimonen, 2015, etc). Click and Weiner (2010) suggest that
the ICRG rating has power to differentiate political risk effects. ICRG’s political risk rating is
based on political information collected by its staff and converted into risk scores. It reflects a
country’s assessment with respect to 12 political dimensions, namely government stability,
socioeconomic conditions, investment profile, internal conflict, external conflict, corruption,
military in politics, religious tensions, law and order, ethnic tensions, democratic
accountability, and bureaucracy quality. This rating varies between 0 and 100. For ease of
interpretation of our results, throughout this study, we code our political risk variables such
that higher values indicate higher political risk. 11 Our main political risk variable (POLRISK)
is calculated as 100 minus the actual value of the composite political risk index reported by
ICRG.
While the political risk composite rating may give an idea on the nature of the impact of
political risk on the cost of equity, it is also of interest to examine whether this impact is driven
by specific dimensions of political risk rather than others. Hence, following Bekaert et al.
(2005) and Bekaert et al. (2014), we decompose the composite rating into four indices that
reflect the quality of institutions, conflict, democratic tendencies, and government actions.12
INSTITUTION is an index that includes a country’s scores on Law and Order, Bureaucratic
Quality, and Corruption. It is equal to 16 minus the score on the quality of institutions
reported by ICRG. CONFLICT is another index that measures a country’s vulnerability to
political unrest. It is the sum of a country’s scores on four sub-components, which are: Internal
Conflicts, External Conflicts, Religious Tensions, and Ethnic Tensions. CONFLICT equals 36
minus the score on conflict reported by ICRG. The third index, labeled DEMOCR, reflects a
country’s inclination towards democracy and includes scores of two sub-components
(Military in Politics and Democratic Accountability). It is equal 12 minus the ICRG index on
11 The political risk rating is performed by assigning risk points to the 12 components, with higher
points denoting lower risks. The components Government stability, Socio-economic conditions,
Investment profile, External conflicts, and Internal conflicts have points ranging from 0 to 12. The
components Ethnic tensions, Religious tensions, Military in politics, Corruption, Law and order, and
Democratic accountability have points ranging from 0 to 6. The component Bureaucracy quality has
points ranging from 0 to 4.
12 Bekaert et al. (2005) decompose the composite political risk index into these four categories based on
their content, but also on an analysis of the correlations between the sub-components across countries
and time.
10
democratic tendencies. The fourth index, called GOVACT, includes ratings on Government
Stability, Socioeconomic Conditions, and Investment Profile. It measures a government’s
ability to stay in office and carry out its policies as well the extent to which investors are legally
protected. GOVACT is calculated as 36 minus the ICRG index on government actions. For
these four indices, higher values indicate a greater political risk.
Besides the ICRG index, in robustness tests, we use the political stability indicator of the World
Bank as an alternative measure of political risk. This indicator reflects perceptions of the
likelihood that the government will be undermined or removed from power by
unconstitutional or violent means, such as politically motivated violence and terrorism. The
index ranges from −2.5 for very politically risky countries to 2.5 for very stable countries. For
ease of interpretation and consistency with our transformed ICRG index, we code the World
Bank political risk index in a way that higher values of the index indicate a higher political
risk. To this end, we multiplied the values of the indicator by (-1).
2.4. Regression model
To test our main hypothesis stating that greater political risk leads to a higher cost of equity
capital, we follow El Ghoul et al (2011) and Hail and Leuz, (2009) and estimate various
specifications of the following model:
R AVG i ,t   0  1 POLRISK tc   2 SIZE i ,t   3 LEV i ,t   4 RVAR i ,t   5 BTM i ,t

  6 DISPi ,t   7 FBIAS i ,t   8 INFL ct   9 LGDPC tc  10 MTURN tc  (6)
J 1 T 1 C 1
   j IND j    t YEAR t    c COUNTRY c   i
j 1 t 1 c 1
where for each firm i in country c, in year t, RAVG is the average of four estimates of the
implied cost of equity capital. POLRISK is our variable of interest and is measured by the
ICRG index of political risk or one of the four sub-component ratings described above. In step
with prior studies (e.g., El Ghoul et al., 2011; Hail and Leuz, 2006, 2009; Dhaliwal et al., 2006),
we include various firm- and country-level controls in our regression model.
SIZE, RVAR, BTM, LEV, DISP, and FBIAS are firm-level controls. SIZE is a control for firm
size and is measured by the natural logarithm of a firm’s total assets. LEV controls for financial
leverage and is measured as the ratio of debt to assets. RVAR is a control for a firm’s risk and
is calculated as the standard deviation of monthly stock returns over the past 12 months. BTM
11
is a control for growth opportunities and is measured by the book-to-market value of equity.
DISP controls for the dispersion in analysts’ forecasts and is equal to the coefficient of
variation of one-year-ahead analyst forecasts of earnings per share. FBIAS is a control for
forecast errors and is calculated as the difference between the one-year-ahead earnings
forecast and realized earnings deflated by beginning of year assets per share.
INFL is a control for a country’s expected inflation rate and is proxied for by the realized
inflation over the coming year. LGDPC controls for a country’s level of economic development
and is equal to the logarithm of GDP per capita. MTURN (market turnover) is a control for a
country’s stock market development and is defined as the ratio of the value of shares traded
to a stock market’s capitalization.
Based on prior empirical studies, we expect the cost of equity capital, RAVG, to exhibit negative
associations with firm size, SIZE13, the logarithm of GDP per capita, LGDPC, and market
turnover, MTURN, (El Ghoul et al., 2011), whereas it is expected to exhibit positive
associations with return variability, RVAR, (Hail and Leuz, 2009), book-to-market ratio,
BMT14, financial leverage, LEV15, analyst dispersion, DISP16, forecast bias, FBIAS17; and
expected inflation, INFL, (Hail and Leuz, 2006).
IND is a set of industry dummies that account for a firm’s industry affiliation based on
Campbell’s (1996) 12-industry classification. YEAR is a set of year dummy variables intended
to control for the potential impact of time or business cycle on firm cost of equity. COUNTRY
is a set of country dummies aimed at capturing country-specific unobserved factors that may
affect firm cost of equity. In particular, country-fixed effects capture the potential impact that
country-level factors, other than those included in the regression equation, can have on firm
cost of equity. In other words, including country-fixed effects can lower the omitted variable
bias. Including country-fixed effects also allows us to capture the impact of within-country
variation in political risk on changes in the cost of equity as each of our sample countries offers
13 Larger firms attract wider media and analyst coverage, which reduces information asymmetry, hence
reducing cost of equity capital (Bowen et al., 2008).
14
Higher book-to-market firms are expected to earn higher ex post returns (Fama and French, 1992,
1993).
15 Financial leverage is known to have a systematic effect on the equity cost of capital (Modigliani and
Miller, 1958)
16 Given the evidence in Gode and Mohanram (2003), we expect analyst dispersion to be positively
related to the cost of equity.

17 For instance, if forecasts tend to be overly optimistic but market participants understand this bias and
adjust prices properly, implied cost of capital models yield estimates with an upward bias.
12
the advantage of substantial changes in its political risk ratings across years. Our empirical
setting permits thus to capture the impact of both between-country and within-country
variation in political risk on the cost of equity.  is an error term. To produce robust estimates,
we correct standard errors for heteroskedasticity and cluster them by firm in all our
regressions.
2.5. Descriptive statistics
Table 1 presents the distribution of our sample observations by country (Panel A), industry
(Panel B), and year (Panel C). Panel A shows that Turkey dominates our sample with more
than 40% of observations followed by Saudi Arabia with 13.6% of observations. Observations
from the four Gulf Cooperation Council (GCC hereafter) countries (Kuwait, Oman, Saudi
Arabia, United Arab Emirates) included in our sample add up to almost 31% of the sample.
In our robustness analyses, we check whether our results are sensitive to excluding Turkey
from the sample and to splitting the sample into two sub-samples: GCC versus non-GCC.
Panel B further shows that our sample is dominated by firms from the finance and real estate
sector (31.2%). We also test the robustness of our findings to the exclusion of finance and real
estate firms from our sample. Panel C reports that most of our observations are in the years of
2005 and forward. For any of the years between 1997 and 2004, observations represent less
than 3% of the total sample. This is no surprise given that in most MENA countries, the
creation of organized stock exchanges is only a recent phenomenon.
[Insert Table 1 about here]
Table 2 reports the cost of equity capital (RAVG) and political risk (POLRISK) by country
(Panels A and B, respectively) and by year (Panels C and D, respectively). As regards the cost
of equity, Panel A indicates that the average cost at which firms raise equity capital varies
between a minimum of 12.92% in Morocco and a maximum of 20.44% in Turkey. This suggests
that although in the same region, MENA firms raise equity capital at rates that vary
extensively across countries. Additionally, statistics in Panel C suggest a great deal of
variability in the cost of equity across years, with a minimum average cost of capital for the
whole region’s firms recorded in 2010 (14.97%) and a maximum observed in 1998 (33.98%).
Likewise, Panel B indicates substantial variation in the extent to which the region’s countries
are exposed to political risk; political risk varies from a minimum of 26.49 in the UAE to a
maximum of 44.13 in Egypt and Lebanon. According to ICRG’s assessment of political risk,
13
Egypt, Lebanon, and Turkey can be considered as high risk countries while the UAE can be
classified as a low risk country. The variation in political risk in the region can also be seen
across years. Panel D of Table 2 indicates that, on average, the whole region’s political risk
was the lowest in 2005 (POLRISK = 33.84) and the highest in 1998 (52.50).
In Table 3, we report summary statistics of all variables used in the multivariate analysis. The
statistics reported in Panel A of Table 3 indicate that besides variability in political risk, our
sample observations present variability across several other dimensions, such as the size of
the firm (SIZE: sd=4.138), financial leverage (LEV: sd=0.241), the level of income (LGDPC:
sd=5.102), expected inflation (INFL: sd=19.78%), and stock market development (MTURN:
sd=62.51%) of the country where they are located. Moreover, Panel B of Table 3 shows how
the implied cost of equity estimates are highly and positively correlated: almost all of them
exhibit a Pearson correlation coefficient of 0.5 and above. Furthermore, Table 4 presents
Pearson correlation coefficients among our variables. It reports a positive and statistically
significant correlation coefficient between political risk and the cost of equity, suggesting that
higher political risk is associated with an increase in firm cost of equity. Table 4 also shows
that most of the correlation coefficients are low, indicating that multi-collinearity is not a
concern for our analysis.
[Insert Tables 3 and 4 about here]
3. Empirical results
In this section, we investigate the relation between political risk and the cost of equity in the
MENA region. We begin by conducting univariate tests that compare the cost of equity across
two sub-samples of observations created based on countries’ level of political risk. We then
provide the results of a multivariate regression analysis of the impact of political risk on firm
cost of equity. Finally, we present the results of various robustness analyses.
3.1. Univariate analysis
In Table 5, we split our sample into two subsamples (Low Risk and High Risk) across the five
variables of political risk – overall political risk (POLRISK), the quality of institutions
(INSTITUTION), democratic tendencies (DEMOCR), Government actions (GOVACT), and
14
conflict (CONFLICT). The Low Risk subsample comprises observations for which political
risk is below the sample median while the High Risk subsample includes observations for
which political risk is above the sample median. We then compare the means and medians of
RAVG across these two subsamples for each of the five variables of political risk. For each of
the latter, we find that RAVG is significantly higher in the High Risk subsample, indicating
that, no matter what dimension of political risk we consider, firms operating in countries
presenting a high political risk to investors face a higher cost of equity capital. For instance, if
we consider the composite political risk index (POLRISK), we find that the mean RAVG is
19.99% (median: 17.22%) in the High Risk subsample while it is 16.11% (median: 13.49%) in
the Low Risk subsample. The difference in means and in medians between the two
subsamples is statistically significant at the 1% level across the five political risk variables.
Overall, our univariate analysis indicates that firms located in countries with a higher political
risk face a higher cost of equity capital. We now turn to the multivariate analysis to see
whether these findings hold when we control for other factors that may affect the cost of
equity capital.
3.2. Multivariate analysis
Table 6 reports our estimations of various specifications of the regression model presented in
eq. (6). We estimate all the regressions with robust standard errors clustered by firm. Column
(1) presents the coefficient estimates of the cost of equity model and their statistical
significance when we exclude POLRISK. It shows that, in line with our expectations and the
findings of prior literature (e.g., Hail and Leuz, 2006), SIZE and LGDPC bear negatively
whereas LEV, RVAR, and BTM bear positively on the cost of equity capital of MENA firms.
In column (2), we include our main variable of interest, POLRISK, and find that, consistent
with our expectations, it loads positive and significant at the 1% level, suggesting that firm
cost of equity increases with country political risk. In other words, investors factor in political
risk when they price the stocks of MENA-based firms. Specifically, they require a premium
for bearing additional political risk. In model (3), we augment our cost of equity model with
further controls (DISP and FBIAS). Consistent with our expectations, both DISP and FBIAS
load positive and significant at the 1% level. Yet, this does not affect the nature of the
association between our main variable of interest, POLRISK, and the cost of equity. POLRISK
continues to load positive (+0.00674) and significant at the 1% level. This finding is also
15
economically significant as our estimation in column (3), which is the full model, indicates
that a one standard deviation increase in POLRISK (6.683) from its mean value leads to an
increase of 450 basis points (4.5%) in the cost of equity. This result suggests that political risk
requires a premium that weighs heavily on the financing costs of firms located in MENA
countries and can lead to the rejection of investment projects that would be accepted had there
been more political stability. Hence, in addition to its negative impact on access to credit of
MENA firms (Turk-Ariss and Herrala, 2016), we find that political risk also increases their
(MENA firms) cost of funding, which can explain, at least partially, the lack of investment and
job creation that characterize many MENA countries.
In column (4) through (7), we differentiate between the various dimensions of political risk
that compose ICRG’s composite political risk index. As indicated earlier in the paper, our goal
is to examine whether the documented association between political risk and cost of equity is
driven by specific political risk dimensions rather than others. Overall, the results reported in
columns (4)-(7) suggest that the four dimensions of political risk identified by Bekaert et al.
(2005; 2014) have a positive and significant impact on the cost of equity of MENA firms. Yet,
the magnitude of this impact varies from one dimension to another. In particular, the risk of
conflict (CONFLICT) has the highest economic impact on the cost of equity while government
action (GOVT) has the lowest one. Our estimations indicate that a one-standard deviation
increase in CONFLICT from its average raises MENA cost of equity capital by 840 basis
points.18 This is no surprise given that CONFLICT reflects a country’s risk of internal (civil
disorder and war, terrorism, and political violence) and external (cross-border conflicts and
wars, foreign pressures) conflicts as well as religious and ethnic tensions. The likelihood of
such conflicts represents a serious threat to investors who can end up losing significant parts
of their capital and return on investment in case such risks materialize into violence. Further,
conflict risk may also be difficult to diversify especially for MENA-local investors as the break
out of conflicts in any of the region’s countries can easily spread out to neighboring countries.
This leads investors to factor in conflict risk when pricing MENA firms’ equity and translates
into higher cost of capital for firms located in countries with a greater conflict risk. Regarding
the three other dimensions of political risk: quality of institutions (INSTITUTION),
Government actions (GOVACT), and Democratic tendencies (DEMOCR), one-standard
18 The CONFLICT index has a sample mean of 10.38 and a standard deviation of 3.67.
16
deviation increase in each of them from its average raises MENA cost of equity capital by 164,
125, and 288 basis points respectively.19
3.3. Robustness checks
3.3.1. Politically Safe versus Politically Unsafe countries
In Table 7, we analyze whether our estimated relation between political risk and the cost of
capital in the MENA region varies across politically safe and unsafe countries. To this end, we
split our sample into two sub-samples: safe and unsafe countries. The subsample of safe
countries contains observations for which ICRG’s political risk index is below the sample
median (POLRISK: 38) and the subsample of unsafe countries contains observations for which
POLRISK is above the sample median. Columns (1) and (2) of Table 7 show that while political
risk is positively associated with the cost of capital in both safe and unsafe countries, the
magnitude of its impact on the cost of capital is much higher in unsafe countries relative to
safe ones. In safe countries, a one-standard deviation increase in political risk from its
subsample average leads to an increase of the cost of equity by 164 basis points.20 In unsafe
countries, the effect of an increase in political risk by one standard deviation translates into a
388 basis point rise in the cost of equity capital. A test of difference in the coefficient estimates
on POLRISK across the two subsamples also reveals a statistically significant difference at the
5% level in favor of the unsafe countries subsample. Further, the explanatory power of our
model is much higher in unsafe countries relative to safe countries; the R-squared increases
from 11.4% to 37.4% as we pass from safe to unsafe countries. This finding indicates that
investors are more sensitive to political risk in politically unsafe countries and require a much
higher political risk premium from firms operating in those countries compared to what they
require from firms in politically safe countries. In columns (3)-(10), we conduct the same
analysis across safe and unsafe countries using the four sub-indices of Bekaert et al. (2005;
2014) intended to capture different dimensions of political risk. Using the institutional
dimension of political risk, columns (3) and (4) show that institutional quality is factored in
by investors only in safe countries; INSTITUTION loads positive and statistically significant
19
The INSTITUTION, GOVACT, and DEMOCR indices has a sample mean of 7.17, 11.49, and 9.01, and
a standard deviation of 0.85, 3.86, and 1.51 respectively.
20 The subsample of safe countries has a mean POLRISK of 32.85 and a standard deviation of 3.74 while
the subsample of unsafe countries has a mean POLRISK of 44.10 and a standard deviation of 3.47.
17
only in the safe countries’ subsample. Obviously, when a country is unsafe, institutional
quality (law and order, bureaucratic quality, and corruption) becomes irrelevant, possibly
because investors are concerned with other dimensions of political risk that can have a more
threatening impact on the value of their investments, such as conflicts. In contrast, in safe
countries, threats due to possible internal and external conflicts are lower and investors’
concerns are more focused on threats that might come from possible institutional weaknesses
and failures.
Columns (5) and (6) suggest that the risk of conflict is priced almost equally in safe and unsafe
countries. CONFLICT loads positive and significant in the two subsamples with nearly the
same economic impact. This indicates that the potential for conflict in the region bears a high
cost on firms, namely in terms of cost of capital. In columns (7) and (8), we turn our attention
to risks stemming from a government’s stability and investor protection (GOVACT). Our
estimations show that this specific dimension of political risk is irrelevant to investors in
politically safe countries while it bears positively on firm cost of capital in politically unsafe
countries; the coefficient estimate on GOVACT is positive and statistically significant only in
the subsample of unsafe countries. This finding suggests that a government’s ability to stay in
office, to carry out its declared programs, to resist social pressure, and to honor its
commitments and contracts becomes a concern to investors only when a country is politically
unsafe. Finally, our estimations reported in columns (9) and (10) reveal that, whether they
invest in politically safe or unsafe countries, investors are not concerned about a country’s
democratic tendencies. Overall, what Table 7 uncovers is that investors in politically safe
countries price risks related to conflicts and institutional quality while those in politically
unsafe countries price conflict risk and threats related to government stability.
3.3.2. Sub-sample analyses
While we have so far reported consistent findings of a positive and significant association
between political risk and MENA firms’ cost of equity, it is possible that these findings are
due to the composition of our sample. Hence, in Table 8, we run various regressions intended
to ensure that our results are not driven by the composition of our sample. In column (1), we
reproduce the results obtained from the estimation of our main model (column 3 of Table 6)
to be used as a benchmark for other models. In column (2), we discard Turkey from the sample
18
to ensure that our results are not due to the presence of Turkish firms, which represent a large
proportion of our observations (40.3%). Excluding Turkey from the sample does not affect our
findings. In fact, POLRISK continues to load positive and statistically and economically
significant, indicating that firms located in MENA countries other than Turkey suffer a higher
cost of capital when political risk increases. In sum, having Turkey among our sample
countries is not driving our main finding of a positive effect of political risk on firm cost of
equity capital. In column (3), we present our estimation of the political risk-cost of capital
relation excluding firms affiliated to the finance and real estate sector, which represent 31.2%
of our total sample. We continue to find a positive and significant statistical and economic
impact of political risk on the cost of equity capital of MENA firms. The coefficient estimate
on POLRISK is positive and significant. It is further higher than in samples including finance
and real estate firms (0.00953 compared to 0.00674 in column (1)), suggesting that non-
financial-and-real estate companies suffer more than their finance-and-real estate peers, in
terms of cost of equity, from rises in political risk. In column (4), we discard observations from
the global financial crisis peak-years (2007, 2008 and 2009). We continue to find a positive and
significant association between political risk and the cost of equity capital, comforting us that
our results are not driven by the global financial crisis.
In columns (5) and (6), we split the sample into GCC and non-GCC subsamples to examine
whether our results are different between non-GCC countries and GCC countries whose
economic and political structures are quite different from the former (non-GCC) countries.
Also these countries are among the richest in the MENA region owing to their oil-based
economies. We find that the coefficient estimate on POLRISK is positive, but no longer
statistically significant, in the GCC sub-sample while it continues to be positive and
statistically significant at the 1% level in the non-GCC subsample. This result indicates that
investors’ concern about political risk and its pricing are rather concentrated in non-GCC
countries. Reasonable explanations of this finding are as follows. First, the levels of political
risk in the GCC region are quite similar across countries and years, which lowers the
variability of our independent variable, POLRISK, and prevents the finding of a significant
association with the cost of capital. Second, investors in the GCC region’s equity markets
would be lured by the idea that listed firms benefit from the support of oil-revenues’ rich
governments and would, thus, be willing to ignore political risk. Crucially for our analysis,
our documented association between political risk and the cost of equity is not driven by
resource-rich GCC countries.
19
3.3.3. Alternative measure of political risk
In Table 9, we present the results of our estimations of the cost of capital model when we use
the political risk index of the World Bank as a measure of political risk instead of the ICRG
political risk score21. Columns (1) and (2) in Table 9 are, respectively, the same as columns (2)
and (3) in Table 6, except that POLRISK is measured by the World Bank political risk indicator
instead of the ICRG indicator. Again, POLRISK, measured by the World Bank indicator, loads
positive and statistically significant at the 1% level indicating that an increase in political risk
is associated with a higher cost of equity capital for MENA firms. Hence, we conclude that
our main finding of a positive association between political risk and the cost of capital is robust
to the use of an alternative proxy for political risk.
3.3.4. Country-level analysis
Firm-level estimation of equation (6) has shown a positive association between political risk
and the cost of capital. Although firm-level regressions have been used in previous studies
where the cost of equity was the dependent variable (e.g., El Ghoul et al., 2011; Hail and Leuz,
2009), other studies relied on country-level analysis (e.g., Hail and Leuz, 2006; Boubakri et al.,
2014). In order to check the robustness of our results to different levels of analysis (firm-level
regression vs. country-level regression), we re-estimate equation (6) at the country level. In all
models shown in Table 10 (columns 1 to 5), the dependent variable is the cost of equity. The
variable of interest in column 1 is the ICRG political risk index (POLRISK), and from column
2 to 5 the four sub-indices introduced in Bekaert et al. (2005; 2014): the quality of institutions
(INSTITUTION) in column 2, conflict (CONFLICT) in column 3, Government actions
(GOVACT) in column 4, and democratic tendencies (DEMOCR) in column 5. Results reported
in Table 10 show that the political risk index, POLRISK, as well as the four sub-indices,
continue to load positive and are statistically significant at the 1% level indicating that an
increase in political risk is associated with a higher cost of equity capital for MENA firms.
Hence, we conclude that our main finding of a positive association between political risk and
21 Pearson correlation coefficient between the ICRG political risk index and the World Bank political
risk measure equals 0.385.
20
the cost of capital is robust to the level of the regression analysis, whether it is done at the firm
level or at the country level.
3.3.5. Robustness to individual model specifications
Our results reported above rely on using the arithmetic average of the four individual costs
of equity, RAVG, as a dependent variable in our main regressions (Table 6). As argued by
Dhaliwal et al. (2006), this reduces the possibility of spurious results associated with the use
of a particular model. Here, we examine whether our core finding is sensitive to using the
individual cost of equity models. Following El Ghoul et al. (2011), we replicate our base model
(Column 3, Table 6) after replacing the dependent variable RAVG with the individual cost of
equity measures, rCT, rGLS, rOJN, and rEaston, as well as the first principal component of these four
metrics. Columns 1 to 5 respectively show that the coefficients on POLRISK keep loading
positively and remain statistically significant. These results reinforce our earlier evidence that
lower political risk results in cheaper equity financing.
4. Conclusion
This study examines the potential effect of political risk on the cost of equity capital in a
politically unstable region – the MENA region. Using a sample of listed firms from ten MENA
countries, the cost of equity implied by share prices and analysts’ forecasts as a measure of
cost of capital, and ICRG’s political risk index as a proxy for political risk, we find that political
risk has a statistically and economically significant impact on firm cost of capital. In particular,
our estimations show that the cost of equity capital increases with political risk. Economically,
our results suggest that a one-standard deviation increase in ICRG’s index from its average
value raises firm cost of equity by 450 basis points.
We further investigate the impact of the various dimensions of political risk embedded in
ICRG’s composite index. Using Bekaert et al.’s (2005; 2014) decomposition of political risk into
four categories – conflict, institutions, democracy, and government actions –, we find that the
risk of conflict weighs heavily on the cost at which MENA firms raise equity capital.
Specifically, we find that conflict risk has the highest economic impact on the cost of capital
21
among the four categories of political risk and that it is relevant in both politically safe and
unsafe countries. Risk related to the quality of institutions is, however, relevant only in safe
countries. Overall, our results indicate that investors in MENA stock markets require a
premium to compensate them for bearing additional political risk. This premium translates
into higher cost of equity capital for firms operating in countries facing higher political risk.
Our results shed light on the importance of political stability for firms. Specifically, political
stability would contribute to the lowering of firms’ cost of raising capital, which is crucial to
their investment capacity. Firms’ access to capital at moderate costs is of utmost importance
especially in countries where private investment is much needed to boost economic growth
and create jobs. While our findings and conclusions are based on the MENA region, their
implications can be relevant to other regions suffering from political instability. Further
research should be dedicated to political risk as a potential driver of underperformance at the
macro-, but also at the micro-firm level.
22
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26
Table 1: Sample Description
Panel A: By country Panel C: By year
Country Count % Year Count %
Egypt 293 10.5% 1997 44 1.6%

Jordan 30 1.1% 1998 56 2.0%
Kuwait 186 6.7% 1999 64 2.3%
Lebanon 73 2.6% 2000 76 2.7%
Morocco 67 2.4% 2001 73 2.6%
Oman 105 3.8% 2002 51 1.8%
Saudi Arabia 381 13.6% 2003 40 1.4%
Turkey 1125 40.3% 2004 49 1.8%
Tunisia 342 12.2% 2005 146 5.2%
United Arab Emirates 193 6.9% 2006 202 7.2%
Total 2795 100% 2007 258 9.2%
2008 319 11.4%
Panel B: By industry
2009 307 11.0%
2010 363 13.0%
Industry Count %
2011 375 13.4%
Basic industry 350 12.5% 2012 372 13.3%
Capital goods 74 2.6% Total 2795 100%
Construction 385 13.8%
Consumer durables 255 9.1%
Finance and real estate 871 31.2%
Food and tobacco 185 6.6%
Leisure 65 2.3%
Petroleum 84 3.0%
Services 64 2.3%
Textiles and trade 88 3.1%
Transportation 74 2.6%
Utilities 300 10.7%
Total 2795 100%
This tables presents the distribution of our sample by country (Panel A), industry as classified
by Campbell (1996) (Panel B), and year (Panel C). Our sample consists of listed firms from ten
MENA countries over the 1997-2012 period.
27
Table 2: Summary statistics of the average cost of equity capital and political risk
Panel A: Cost of equity capital by country Panel B: Political risk by country
Standard Standard
Country N Mean p25 p50 p75 N Mean p25 p50 p75
Deviation Deviation
Egypt 293 18.10% 8.48% 12.78% 17.02% 20.61% 293 44.13 4.35 40.00 44.00 50.50
Jordan 30 14.11% 7.49% 9.06% 11.75% 15.34% 30 35.64 3.64 33.50 34.00 35.50
Kuwait 186 18.95% 12.37% 11.51% 14.49% 21.98% 186 30.96 3.12 28.00 31.50 35.00
Lebanon 73 17.04% 3.72% 14.78% 17.32% 19.28% 73 44.13 2.78 43.50 44.50 46.50
Morocco 67 12.92% 5.20% 9.39% 11.49% 14.55% 67 34.85 1.42 34.25 35.75 35.75
Oman 105 14.85% 6.42% 11.91% 14.19% 16.80% 105 32.22 3.68 29.00 31.00 37.00
Saudi Arabia 381 14.11% 10.22% 8.09% 9.97% 14.62% 381 35.99 1.12 35.00 36.00 37.00
Turkey 1,125 20.44% 12.22% 12.86% 16.81% 23.73% 1,125 43.19 4.15 41.50 44.00 44.50
Tunisia 342 17.46% 10.18% 9.21% 14.92% 24.57% 342 33.84 3.89 31.00 32.00 40.50
United Arab Emirates 193 16.77% 8.54% 10.86% 14.86% 20.80% 193 26.49 0.77 26.00 26.50 27.50
Total 2,795 18.07% 10.89% 10.99% 15.32% 21.53% 2,795 38.53 6.68 34.00 38.00 44.50
Panel C: Cost of equity capital by year Panel D: Political risk by year
Standard Standard
Country N Mean p25 p50 p75 N Mean p25 p50 p75
Deviation Deviation
1997 44 24.84% 11.36% 13.69% 25.96% 30.64% 44 48.50 0.00 48.50 48.50 48.50
1998 56 33.93% 18.88% 17.56% 33.77% 49.73% 56 52.50 0.00 52.50 52.50 52.50
1999 64 29.08% 16.14% 17.80% 24.33% 38.33% 64 49.36 2.96 50.00 50.00 50.00
2000 76 17.42% 8.97% 9.88% 17.32% 23.30% 76 41.01 1.16 41.50 41.50 41.50
2001 73 29.42% 16.23% 18.29% 23.70% 36.61% 73 43.34 3.69 38.00 45.50 45.50
2002 51 31.51% 15.76% 20.53% 30.74% 41.82% 51 43.26 1.78 44.00 44.00 44.00
2003 40 20.90% 10.91% 13.58% 19.54% 25.13% 40 41.33 0.60 41.50 41.50 41.50
2004 49 16.97% 8.17% 12.35% 14.83% 19.61% 49 36.13 2.39 36.75 36.75 36.75
2005 146 19.58% 10.13% 12.54% 16.38% 26.47% 146 33.84 3.40 32.00 34.75 34.75
2006 202 16.91% 8.33% 12.43% 15.66% 20.05% 202 35.03 4.34 31.00 37.50 37.50
2007 258 14.24% 7.79% 9.04% 11.90% 17.51% 258 35.96 5.36 31.75 39.50 39.50
2008 319 20.19% 11.79% 12.37% 17.57% 25.89% 319 35.92 6.54 29.00 36.00 42.25
2009 307 16.56% 8.30% 11.14% 14.51% 19.98% 307 36.34 6.14 32.00 34.00 43.00
2010 363 14.97% 7.77% 10.28% 13.50% 17.45% 363 37.23 6.74 31.00 35.00 44.50
2011 375 16.65% 9.36% 10.50% 14.52% 20.47% 375 40.26 6.08 37.00 40.50 44.50
2012 372 15.44% 7.99% 10.45% 13.94% 18.39% 372 40.37 6.07 37.00 40.50 44.50
Total 2,795 18.07% 10.89% 10.99% 15.32% 21.53% 2,795 38.53 6.68 34.00 38.00 44.50
This table presents the descriptive statics of the cost of equity financing and political risk by country (Panel A and B, respectively) and by year (Panel C and D, respectively). The
cost of equity financing is the average cost of equity derived from the four following models: Gebhardt et al. (2001), Claus and Thomas (2001), Easton (2004), and Ohlson and
Juettner-Nauroth (2005). Political Risk is calculated as 100 minus the ICRG Political index.
Table 3: Summary statistics of the variables used in the multivariate analysis
Panel A: Descriptive statistics

variable N mean sd p25 p50 p75
POLRISK 2795 38.528 6.683 34.000 38.000 44.500
RAVG 2795 0.181 0.109 0.110 0.153 0.215
RCT 2795 0.170 0.112 0.093 0.143 0.212
RGLS 2795 0.168 0.108 0.097 0.146 0.213
ROJN 2795 0.191 0.098 0.120 0.164 0.224
REaston 2795 0.194 0.118 0.107 0.160 0.233
LEV 2781 0.907 0.241 0.969 0.991 0.994
SIZE 2781 17.493 4.138 14.122 16.414 22.417
RVAR 2795 0.123 0.066 0.084 0.102 0.140
BTM 2768 0.644 0.543 0.362 0.476 0.775
DISP 2755 0.228 0.195 0.125 0.200 0.267
FBIAS 2791 0.025 0.963 -0.010 0.090 0.137
INFL 2703 13.594 19.789 4.410 6.472 10.444
LGDPC 2795 1.780 5.102 0.195 3.358 5.301
MTURN 2795 93.699 62.513 29.756 111.064 141.722
INSTITUTIONS 2795 7.176 0.850 6.500 7.000 8.000
CONFLICT 2795 10.386 3.676 7.000 10.000 13.750
GOVACT 2795 11.948 3.862 9.500 12.500 14.500
DEMOCR 2795 9.017 1.516 8.000 9.500 10.000
Panel B: Pearson correlation coefficients between implied cost of equity estimates
RAVG RCT RGLS ROJN REaston
RAVG 1.000
RCT 0.723 1.000
RGLS 0.746 0.538 1.000
ROJN 0.896 0.562 0.486 1.000
REaston 0.896 0.482 0.493 0.911 1.000
This table presents descriptive statistics of firm- and country-level variables used in the multivariate analysis
(Panel A) as well as correlations between cost of equity estimates (Panel B). The sample consists of firms from ten
MENA countries over the 1997-2012 period. POLRISK is a measure of political risk that equals 100 minus ICRG’s
political risk index. RAVG is the cost of equity financing calculated as the average cost of equity derived from four
different models. LEV is a measure of financial leverage calculated by the debt to assets ratio. SIZE is a measure
of firm size that equals the natural logarithm of a firm’s total assets. RVAR is a measure of firm risk calculated as
the standard deviation of monthly stock returns over the past 12 months. BTM is calculated as the book to market
value of equity. DISP is a measure of analysts’ dispersion and is measured by the coefficient of variation of one-
year-ahead analyst forecasts of earnings per share. FBIAS is a control for forecast errors measured as the difference
between the one-year-ahead earnings forecast and realized earnings deflated by beginning of year assets per
share. INFL equals the realized inflation rate over the coming year. LGDPC equals the natural logarithm of GDP
per capita. MTURN equals is a measure of market turnover calculated as the ratio of the value of shares traded to
a stock market’s capitalization.
Table 4: Pearson correlation coefficients
RAVG POLRISK SIZE LEV RVAR BTM DISP FBIAS INFL LGDPC MTURN INSTITUTION CONFLICT GOVACT DEMOCR
RAVG 1.000
POLRISK 0.206 1.000

0.000
SIZE -0.186 -0.437 1.000
0.000 0.000
LEV 0.011 -0.112 0.353 1.000
0.564 0.000 0.000
RVAR 0.250 0.313 -0.412 -0.069 1.000
0.000 0.000 0.000 0.000
BTM 0.118 0.070 -0.214 -0.089 0.053 1.000
0.000 0.000 0.000 0.000 0.005
DISP 0.164 0.147 -0.107 0.001 0.181 0.134 1.000
0.000 0.000 0.000 0.954 0.000 0.000
FBIAS 0.039 -0.055 -0.052 0.011 0.067 -0.058 0.053 1.000
0.038 0.004 0.006 0.552 0.000 0.002 0.005
INFL 0.328 0.559 -0.488 -0.091 0.654 -0.057 0.094 -0.037 1.000
0.000 0.000 0.000 0.000 0.000 0.003 0.000 0.056
LGDPC -0.136 0.194 0.071 0.028 -0.132 -0.228 -0.069 -0.041 -0.049 1.000
0.000 0.000 0.000 0.140 0.000 0.000 0.000 0.030 0.012
MTURN 0.083 0.326 -0.354 -0.122 0.310 0.079 0.210 0.020 0.352 0.099 1.000
0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.299 0.000 0.000
INSTITUTION 0.147 0.753 -0.328 -0.107 0.184 0.016 0.081 -0.073 0.320 0.177 0.161 1.000
0.000 0.000 0.000 0.000 0.000 0.401 0.000 0.000 0.000 0.000 0.000
CONFLICT 0.154 0.827 -0.517 -0.139 0.262 0.152 0.173 -0.100 0.501 0.133 0.576 0.509 1.000
0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
GOVACT 0.194 0.891 -0.368 -0.098 0.312 0.056 0.107 -0.041 0.468 0.182 0.107 0.650 0.570 1.000
0.000 0.000 0.000 0.000 0.000 0.003 0.000 0.031 0.000 0.000 0.000 0.000 0.000
DEMOCR -0.042 -0.287 0.448 0.153 -0.154 -0.212 -0.090 0.147 -0.124 -0.029 -0.321 -0.130 -0.519 -0.368 1.000
0.026 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.122 0.000 0.000 0.000 0.000
31
Table 5: Univariate analysis
Means Medians
Political Risk - Low Political Risk - High Political Risk - Low Political Risk - High
(2) - (1) (2) - (1)
(1) (2) (1) (2)
[t-stat] [z-stat]
Cost of Equity 16.11% 19.99% (3.88%)*** 13.49% 17.22% (3.74%)***
[9.5559] [ 11.330]
Quality of Institutions - Low Risk Quality of Institutions - High Risk Quality of Institutions - Low Risk Quality of Institutions - High Risk
(2) - (1) (2) - (1)
(1) (2) (1) (2)
[t-stat] [z-stat]
Cost of Equity 17.27% 19.77% (2.5%)*** 14.37% 17.01% (2.64%)***
[5.6980] [7.986]
Democratic tendencies - Low Risk Democratic tendencies - High Risk Democratic tendencies - Low Risk Democratic tendencies - High Risk
(2) - (1) (2) - (1)
(1) (2) (1) (2)
[t-stat] [z-stat]
Cost of Equity 17.60% 18.41% (0.82%)*** 14.16% 15.85% (1.69%)***
[1.9546] [5.578]
Government Actions - Low Risk Government Actions - Low Risk Government Actions - Low Risk Government Actions - Low Risk
(2) - (1) (2) - (1)
(1) (2) (1) (2)
[t-stat] [z-stat]
Cost of Equity 15.95% 20.51% (4.56%)*** 13.50% 17.40% (3.9%)***
[11.27] [12.793]
Conflict - Low Risk Conflict - Low Risk Conflict - Low Risk Conflict - Low Risk
(2) - (1) (2) - (1)
(1) (2) (1) (2)
[t-stat] [z-stat]
Cost of Equity 16.86% 19.39% (2.53%)*** 14.31% 16.59% (2.28%)***
[6.1695] [7.112]
This table presents the results of t-tests for differences in mean of the cost of equity as well as the results of z-test for differences in median of the cost of equity run on different subsamples. Panel A
presents the results of t-tests ad z-tests run using a sample of low Political Risk and another sample of high political risk; Low vs. High political risk is determined using the median of Political Risk,
which is equal to 100 minus the ICRG Political Risk Index. Panel B, C, D, and E present the results of t-tests ad z-tests run using the for components of political risk as defined in Bakeart et al. (2014):
(1) Quality of Insitutions, (2) Conflict, (3) Democratic tendencies, and (4) Government Actions. Panel B presents the results of t-tests ad z-tests run using a sample of low Quality of Institutions vs. high
Quality of Institutions. Quality of Intitutions equals 16 minus the ICRG index for Quality of Institutions: the higher the value of our index, the higher is the risk. Panel C presents the results of t-tests ad
z-tests run using a sample of low Democratic Tendencies vs. high Democratic Tendencies. Democratic Tendencies equals 12 minus the ICRG index for Democratic Tendencies: the higher the value of
our index, the higher is the risk. Panel D presents the results of t-tests ad z-tests run using a sample of low Government Actions vs. high Government Actions. Government Actions equals 36 minus the
ICRG index for Government Actions: the higher the value of our index, the higher is the risk. Finally, Panel E presents the results of t-tests ad z-tests run using a sample of low Conflict vs. high
conflict. Conflict equals 36 minus the ICRG index for Conflict: the higher the value of our index, the higher is the risk.
32
Table 6: Regression Analysis: Political risk and the cost of capital in the MENA region
VARIABLES (1) (2) (3) (4) (5) (6) (7)
SIZE -0.0105*** -0.0103*** -0.00983*** -0.00995*** -0.0102*** -0.00985*** -0.0101***

(-6.086) (-5.999) (-5.734) (-5.785) (-5.932) (-5.745) (-5.893)
LEV 0.0441*** 0.0435*** 0.0410*** 0.0409*** 0.0411*** 0.0413*** 0.0413***
(5.280) (5.234) (5.005) (4.974) (4.997) (5.033) (5.032)
RVAR 0.0860* 0.0732 0.0499 0.0689 0.0520 0.0548 0.0665
(1.752) (1.506) (1.051) (1.437) (1.096) (1.150) (1.389)
BTM 0.0236*** 0.0215*** 0.0199*** 0.0230*** 0.0198*** 0.0212*** 0.0214***
(5.370) (4.850) (4.394) (5.075) (4.391) (4.642) (4.749)
DISP 0.0477*** 0.0503*** 0.0483*** 0.0496*** 0.0501***
(4.042) (4.215) (4.094) (4.172) (4.203)
FBIAS 0.00514*** 0.00536*** 0.00496*** 0.00540*** 0.00546***
(2.717) (2.831) (2.660) (2.878) (2.912)
INFL -0.000370 -0.00115** -0.00126*** -0.000618 -0.000148 -0.000800* -0.000921**
(-0.843) (-2.574) (-2.780) (-1.452) (-0.345) (-1.654) (-2.057)
LGDPC -0.00308*** -0.00163** -0.00143** -0.00282*** -0.00179*** -0.00229*** -0.00280***
(-5.151) (-2.534) (-2.215) (-4.770) (-3.006) (-3.626) (-4.725)
MTURN -1.82e-06 -0.000133 -0.000139* -0.000138 -0.000129 -2.10e-05 -9.97e-05
(-0.0226) (-1.594) (-1.673) (-1.511) (-1.571) (-0.263) (-1.151)
POLRISK 0.00702*** 0.00674***
(5.735) (5.448)
INSTITUTION 0.0193***
(3.254)
CONFLICT 0.0229***
(6.469)
GOVACT 0.00325*
(1.946)
DEMOCR 0.0191***
(2.733)
Constant 0.239*** 0.0617 0.0588 0.116** 0.0890** 0.216*** 0.0525
(8.271) (1.496) (1.413) (2.528) (2.500) (7.357) (0.735)
Observations 2,694 2,694 2,686 2,686 2,686 2,686 2,686

R2 0.237 0.245 0.254 0.249 0.259 0.248 0.248
This table presents the results of the estimation of our cost of capital model using the ICRG political risk index as a measure of political risk (POLRISK). Our sample consists of
listed firms from ten MENA countries over the 1997-2012 period. We code our political risk variables such that higher values indicate higher political risk. For instance, POLRISK
is calculated as 100 minus the actual value reported by ICRG. We regress the cost of equity capital (RAVG) on POLRISK as well as firm- and country-level controls, including
firm size (SIZE), debt-to-assets ratio (LEV), return variability (RVAR), book-to-market ratio (BTM), analysts’ forecast dispersion (DISP), analyst forecasting bias (FBIAS), the
expected inflation for the next 12 months (INFL), GDP per capita (LGDPC), and stock market turnover (MTURN). INSTITUTION (quality of institutions), CONFLICT, GOVACT
(Government actions), and DEMOCR (democratic tendencies) are categories of political risk identified by Bekaert et al. (2014). All regression models are estimated including
year, industry, and country fixed effects. Standard errors are corrected for heteroskedasticity and clustered by firm. Robust t-statistics are reported in parentheses. Significance
levels are as follows: *** p<0.01, ** p<0.05, * p<0.1.
34
Table 7: Political risk and the cost of equity capital in the MENA region: Safe vs. Unsafe countries
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
VARIABLES
Safe Unsafe Safe Unsafe Safe Unsafe Safe Unsafe Safe Unsafe
SIZE -0.00406 -0.0131*** -0.00395 -0.0132*** -0.00462* -0.0131*** -0.00405 -0.0131*** -0.00407 -0.0131***
(-1.568) (-5.715) (-1.521) (-5.722) (-1.798) (-5.725) (-1.559) (-5.723) (-1.565) (-5.711)
LEV 0.0325*** 0.0476*** 0.0341*** 0.0464*** 0.0335*** 0.0468*** 0.0334*** 0.0477*** 0.0336*** 0.0465***
(3.088) (4.526) (3.208) (4.403) (3.222) (4.428) (3.147) (4.533) (3.137) (4.421)
RVAR 0.201** -0.0741 0.200** -0.0681 0.161** -0.0573 0.210*** -0.0858 0.210*** -0.0617
(2.536) (-1.217) (2.524) (-1.119) (2.015) (-0.947) (2.634) (-1.400) (2.618) (-1.029)
BTM -0.00723 0.0285*** -0.00508 0.0296*** -0.00486 0.0288*** -0.00791 0.0286*** -0.00779 0.0297***
(-1.028) (5.003) (-0.736) (5.192) (-0.688) (5.06) (-1.127) (5.02) (-1.113) (5.201)
DISP 0.0297 0.0524*** 0.0289 0.0590*** 0.0262 0.0552*** 0.03 0.0524*** 0.0301 0.0592***
(1.598) (3.781) (1.536) (4.206) (1.415) (3.959) (1.608) (3.777) (1.616) (4.208)
FBIAS -0.00079 0.00771*** -0.00096 0.00825*** -0.00027 0.00774*** -0.00095 0.00803*** -0.00098 0.00800***
(-0.294) (3.36) (-0.361) (3.595) (-0.103) (3.362) (-0.361) (3.466) (-0.368) (3.494)
INFL 0.00217 0.000302 0.000476 0.00227*** 0.00174 0.00232*** 0.00119 0.000103 0.00111 0.00169**
(1.072) (0.435) (0.232) (2.727) (0.882) (3.016) (0.59) (0.152) (0.526) (2.527)
LGDPC 0.00142 0.00453** 0.00144 0.00399 0.00133 0.00292 0.000482 0.00545** 0.000518 0.00343*
(1.311) (2.158) (1.293) (1.601) (1.426) (1.397) (0.477) (2.515) (0.548) (1.72)
MTURN 0.000163 -0.0021*** 0.000192 -0.0024*** 0.000201* -0.0019*** 0.000179 -0.0022*** 0.000187 -0.0025***
(1.35) (-3.775) (1.591) (-4.142) (1.7) (-3.314) (1.483) (-4.060) (1.442) (-4.664)
POLRISK 0.00474** 0.0112***
(2.003) (4.879)
INSTITUTION 0.0319** -0.0205
35
(2.083) (-0.959)
CONFLICT 0.0243*** 0.0258***
(3.878) (3.788)
GOVACT -0.00012 0.0145***
(-0.0425) (4.68)
DEMOCR -0.0045 0.0133
(-0.185) 0.483)
Constant 0.0375 0.0813 -0.0204 0.771*** 0.00903 -0.00747 0.165*** 0.394*** 0.207 0.515**
(0.48) (0.627) (-0.208) (3.407) (0.152) (-0.0888) (3.525) (4.687) (0.881) (2.424)
Observations 1,349 1,337 1,349 1,337 1,349 1,337 1,349 1,337 1,349 1,337
R2 0.114 0.374 0.114 0.368 0.123 0.371 0.111 0.374 0.111 0.368
This table presents the results of estimations of our cost of equity capital across two subsamples: Safe and Unsafe countries. The subsample of safe (Unsafe)
countries contains observations for which POLRISK is below (above) its full sample median (38.00 Our sample consists of listed firms from ten MENA
countries over the 1997-2012 period. We code our political risk variables such that higher values indicate higher political risk. For instance, POLRISK is
calculated as 100 minus the actual value reported by ICRG. We regress the cost of equity capital (RAVG) on POLRISK as well as firm- and country-level
controls, including firm size (SIZE), debt-to-assets ratio (LEV), return variability (RVAR), book-to-market ratio (BTM), analysts’ forecast dispersion (DISP),
analyst forecasting bias (FBIAS), the expected inflation for the next 12 months (INFL), GDP per capita (LGDPC), and stock market turnover (MTURN).
INSTITUTION (quality of institutions), CONFLICT, GOVACT (Government actions), and DEMOCR (democratic tendencies) are categories of political risk
identified by Bekaert et al. (2014). All regression models are estimated including year, industry, and country fixed effects. Standard errors are corrected for
heteroskedasticity and clustered by firm. Robust t-statistics are reported in parentheses. Significance levels are as follows: *** p<0.01, ** p<0.05, * p<0.1.
36
Table 8: Political risk and the cost of equity capital in the MENA region: Sub-sample analyses
Main Model No Turkey No Finance and No Global Financial GCC No GCC
Real Estate Crisis
VARIABLES (1) (2) (3) (4) (5) (6)
POLRISK 0.00674*** 0.00451** 0.00953*** 0.00550*** 0.00347 0.00479***

(5.448) (2.527) (6.515) (4.078) (0.988) (3.565)
SIZE -0.00983*** 0.000101 -0.0149*** -0.0109*** -0.0225 -0.0101***
(-5.734) (0.0412) (-6.727) (-5.144) (-1.019) (-5.668)
LEV 0.0410*** 0.0300*** 0.0507*** 0.0372*** -0.969 0.0417***
(5.005) (3.279) (5.533) (3.619) (-0.224) (5.061)
RVAR 0.0499 0.135** 0.0380 -0.0886 0.196 0.0252
(1.051) (2.373) (0.670) (-1.521) (0.424) (0.530)
BTM 0.0199*** 0.00383 0.0114** 0.0316*** -0.0886 0.0217***
(4.394) (0.539) (2.279) (4.902) (-1.494) (4.705)
DISP 0.0477*** 0.0885*** 0.0390*** 0.0410*** -0.00164 0.0476***
(4.042) (4.295) (2.999) (2.861) (-0.0109) (4.049)
FBIAS 0.00514*** 0.000188 0.00384* 0.00206 0.201 0.00498***
(2.717) (0.105) (1.654) (1.028) (1.255) (2.727)
INFL -0.00126*** 0.00224 -0.00168*** -0.000420 0.00480 -0.000594
(-2.780) (1.345) (-3.221) (-0.774) (0.817) (-1.260)
LGDPC -0.00143** 0.000716 -0.00117 -0.000759 0.000877 -0.00181***
(-2.215) (0.757) (-1.377) (-0.726) (0.263) (-2.945)
MTURN -0.000139* 0.000178 -0.000163 6.48e-05 -8.80e-05 -0.000344**
(-1.673) (1.577) (-1.585) (0.600) (-0.278) (-2.526)
Constant 0.0588 -0.0310 0.0607 0.105** 1.497 0.124***
(1.413) (-0.492) (1.249) (2.049) (0.338) (2.742)
Observations 2,686 1,563 1,905 1,834 565 2,121

R2 0.254 0.133 0.275 0.295 0.186 0.307
This table presents the results of the estimation of our cost of capital model using the ICRG political risk index as a measure of political risk (POLRISK). Our sample consists
of listed firms from ten MENA countries over the 1997-2012 period. We code our political risk variables such that higher values indicate higher political risk. POLRISK is
calculated as 100 minus the actual value reported by ICRG. We regress the cost of equity capital (RAVG) on POLRISK as well as firm- and country-level controls, including
firm size (SIZE), debt-to-assets ratio (LEV), return variability (RVAR), book-to-market ratio (BTM), analysts’ forecast dispersion (DISP), analyst forecasting bias (FBIAS), the
expected inflation for the next 12 months (INFL), GDP per capita (LGDPC), and stock market turnover (MTURN). All regression models are estimated including year, industry,
and country fixed effects. Standard errors are corrected for heteroskedasticity and clustered by firm. Robust t-statistics are reported in parentheses. Significance levels are as
follows: *** p<0.01, ** p<0.05, * p<0.1.
37
Table 9: Political risk and the cost of equity capital in the MENA region
VARIABLES (1) (2)
POLRISK 0.0622*** 0.0602***

(3.901) (3.776)
SIZE -0.0104*** -0.00987***
(-5.996) (-5.747)
LEV 0.0440*** 0.0415***
(5.268) (5.052)
RVAR 0.0858* 0.0620
(1.755) (1.300)
BTM 0.0231*** 0.0215***
(5.261) (4.784)
DISP 0.0469***
(3.977)
FBIAS 0.00568***
(2.921)
INFL -0.000940** -0.00104**
(-2.053) (-2.249)
LGDPC -0.00171** -0.00151**
(-2.378) (-2.089)
MTURN -8.60e-05 -9.56e-05
(-1.035) (-1.156)
Constant 0.294*** 0.282***
(9.157) (8.814)
Observations 2,694 2,686

R2 0.242 0.251
This table presents the results of the estimation of our cost of capital model using the
World Bank political risk index as a measure of political risk (POLRISK). The index ranges
from −2.5 for very politically risky countries to 2.5 for very stable countries. For ease of
interpretation and consistency with our ICRG index, we code the World Bank political
risk index in a way that higher values of the index indicate a higher political risk. To this
end, we multiplied the values of the indicator by (-1). Our sample consists of listed firms
from ten MENA countries over the 1997-2012 period. We regress the cost of equity capital
(RAVG) on POLRISK as well as firm- and country-level controls, including firm size
(SIZE), debt-to-assets ratio (LEV), return variability (RVAR), book-to-market ratio (BTM),
analysts’ forecast dispersion (DISP), analyst forecasting bias (FBIAS), the expected
inflation for the next 12 months (INFL), GDP per capita (LGDPC), and stock market
turnover (MTURN). All regression models are estimated including year, industry, and
country fixed effects. Standard errors are corrected for heteroskedasticity and clustered
by firm. Robust t-statistics are reported in parentheses. Significance levels are as follows:
*** p<0.01, ** p<0.05, * p<0.1.
38
Table 10: Country-level regressions: the cost of equity and political risk
VARIABLES (1) (2) (3) (4) (5)
SIZE -0.0071*** -0.0042*** -0.0066*** -0.0075*** -0.0092**

(-3.487) (-3.712) (-3.042) (-3.672) (-3.194)
LEV 0.0381*** 0.0164*** 0.0249*** 0.0461*** 0.0118***
(3.281) (3.102) (3.622) (4.081) (3.069)
RVAR 0.0184 0.0246 0.0218 0.0402 0.0065
(1.006) (1.229) (0.876) (1.027) (1.172)
BTM 0.0265*** 0.0364*** 0.0112*** 0.0482*** 0.0194***
(4.006) (4.246) (5.281) (5.184) (4.045)
DISP 0.0384*** 0.0258*** 0.0168*** 0.0406*** 0.0176***
(5.065) (4.662) (4.558) (4.994) (5.164)
FBIAS 0.0618*** 0.0281*** 0.0318*** 0.0195*** 0.0294***
(3.784) (3.831) (4.165) (3.487) (3.941)
INFL -0.0217 -0.0008 -0.0003 -0.0027 -0.0012
(-0.945) (-0.752) (-1.387) (-0.882) (-1.028)
LGDPC -0.0018*** -0.0047*** -0.0029*** -0.0185*** -0.0093***
(-4.373) (-4.004) (-4.251) (-3.816) (-4.046)
MTURN -0.0021 -0.0016 -0.0040 -0.0027 -0.0018
(-1.149) (-1.020) (-1.228) (-0.861) (-0.967)
POLRISK 0.0055***
(4.127)
INSTITUTION 0.0122**
(3.254)
CONFLICT 0.0081***
(3.069)
GOVACT 0.0018*
(2.371)
DEMOCR 0.0014***
(2.616)
Constant 0.0525*** 0.1185*** 0.0857*** 0.1372*** 0.0923***
(4.436) (3.682) (4.058) (6.322) (4.713)
Observations 158 158 158 158 158

R2 0.213 0.203 0.207 0.194 0.201
This table presents the results of the country-level regressions of the cost of equity (median by country) on the ICRG political risk
indices as measures of political risk (POLRISK). We regress the country-level cost of equity capital (RAVG, median) on POLRISK
as well as other controls, including firm size (SIZE, median by country), debt-to-assets ratio (LEV, median by country), return
variability (RVAR, median by country), book-to-market ratio (BTM, median by country), analysts’ forecast dispersion (DISP,
median by country), analyst forecasting bias (FBIAS, median by country), the expected inflation for the next 12 months (INFL),
GDP per capita (LGDPC), and stock market turnover (MTURN). INSTITUTION (quality of institutions), CONFLICT, GOVACT
(Government actions), and DEMOCR (democratic tendencies) are categories of political risk identified by Bekaert et al. (2014). All
regression models are estimated including year fixed effects. Standard errors are corrected for heteroskedasticity. Robust t-statistics
are reported in parentheses. Significance levels are as follows: *** p<0.01, ** p<0.05, * p<0.1.
39
Table 11: Robustness to different model specifications of the cost of equity capital
VARIABLES Claus and Gebhardt et al. Ohlson and Easton (2004) First Principal
Thomas (2001) (2001) Juettner-Nauroth Component
(2005)
SIZE -0.0112*** -0.0187*** -0.0248*** -0.0027*** -0.0092***
(-4.238) (-5.003) (-4.206) (-5.331) (-4.761)
LEV 0.0619*** 0.0533*** 0.0481*** 0.0233*** 0.0334***
(5.623) (4.021) (4.381) (7.136) (5.122)
RVAR 0.1172 0.0945 0.0902 0.0703 0.1043
(1.033) (1.008) (0.895) (0.936) (0.977)
BTM 0.0122*** 0.0183*** 0.0305*** 0.0277*** 0.0203***
(4.003) (5.128) (4.288) (3.611) (4.093)
DISP 0.0145*** 0.0277*** 0.0319*** 0.0483*** 0.0267***
(5.819) (5.004) (4.771) (4.905) (5.438)
FBIAS 0.0108*** 0.0085*** 0.0097*** 0.0113*** 0.0106***
(3.912) (4.056) (4.295) (3.691) (3.827)
INFL -0.0009 -0.0003 -0.0002 -0.0008 -0.0006
(-0.450) (-1.381) (-0.681) (-1.236) (-1.003)
LGDPC -0.0011*** -0.0023*** -0.0015*** -0.0016*** -0.0019***
(-3.845) (-4.043) (-3.818) (-3.991) (-4.127)
MTURN -0.0000 -0.0000 -0.0001 -0.0001 -0.0001
(-1.003) (-1.185) (-1.256) (-0.967) (-1.062)
POLRISK 0.0081*** 0.0052*** 0.0063*** 0.0056*** 0.0060***
(4.027) (3.439) (5.002) (3.761) (4.362)
Constant 0.1284*** 0.0923*** 0.0143** 0.0248*** 0.0743***
(3.651) (4.194) (6.599) (4.016) (4.728)
Observations 2,686 2,686 2,686 2,686 2,686

R2 0.262 0.241 0.251 0.248 0.259
This table presents the results of the estimation of different individual cost of equity capital metrics on POLRISK as well as firm- and
country-level controls, including firm size (SIZE), debt-to-assets ratio (LEV), return variability (RVAR), book-to-market ratio (BTM),
analysts’ forecast dispersion (DISP), analyst forecasting bias (FBIAS), the expected inflation for the next 12 months (INFL), GDP per
capita (LGDPC), and stock market turnover (MTURN). INSTITUTION (quality of institutions), CONFLICT, GOVACT (Government
actions), and DEMOCR (democratic tendencies) are categories of political risk identified by Bekaert et al. (2014). The dependent variable
is the cost of equity given by Claus and Thomas (2001) model (Column 1), Gebhardt et al. (2001) model (Column 2), Ohlson and Juettner-
Nauroth (2005) model (Column 3), and Easton (2004) model (Column 4), and the first principal component of the costs of equity given
by the four models (Column 5).All regression models are estimated including year, industry, and country fixed effects. Standard errors
are corrected for heteroskedasticity and clustered by firm. Robust t-statistics are reported in parentheses. Significance levels are as
follows: *** p<0.01, ** p<0.05, * p<0.1.
40

Political Risk and The Cost of Capital in The MENA Region

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Political Risk and The Cost of Capital in The MENA Region

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Political risk and the cost of capital in the MENA region

Forthcoming, Emerging Markets Review

Key words: Political risk, Institutions, cost of capital, MENA, investment.

Electronic copy available at: https://ssrn.com/abstract=3027987

Electronic copy available at: https://ssrn.com/abstract=3027987

and United Arab Emirates.

6 These statistics are available on www.enterprisesurveys.com (accessed on May 12, 2016).

2.2. Cost of equity estimates

2.2.1. Claus and Thomas (2001) model

2.2.2. Gebhardt et al. (2001) model

2.2.3. Ohlson and Juettner-Nauroth (2005) model

𝑥̂𝑡+1 𝑔 +𝑟 .𝑑̂ /𝑥̂ −𝑔

2.2.4. Easton (2004) model

𝑥̂𝑡+2 +𝑟𝐸𝑎𝑠𝑡𝑜𝑛 .𝑑̂𝑡+1 −𝑥̂𝑡+1

2.3. Political Risk Measures

2.4. Regression model

R AVG i ,t   0  1 POLRISK tc   2 SIZE i ,t   3 LEV i ,t   4 RVAR i ,t   5 BTM i ,t

related to the cost of equity.

2.5. Descriptive statistics

[Insert Table 1 about here]

[Insert Table 2 about here]

[Insert Tables 3 and 4 about here]

3.1. Univariate analysis

[Insert Table 5 about here]

3.2. Multivariate analysis

[Insert Table 6 about here]

3.3. Robustness checks

3.3.1. Politically Safe versus Politically Unsafe countries

[Insert Table 7 about here]

3.3.2. Sub-sample analyses

3.3.3. Alternative measure of political risk

[Insert Table 9 about here]

3.3.4. Country-level analysis

[Insert Table 10 about here]

3.3.5. Robustness to individual model specifications

[Insert Table 11 about here]

Perotti, E. 1995. Credible privatization. American Economic Review, 85, 847–859.

Panel A: By country Panel C: By year

Country Count % Year Count %

Egypt 293 10.5% 1997 44 1.6%

Panel A: Cost of equity capital by country Panel B: Political risk by country

Panel C: Cost of equity capital by year Panel D: Political risk by year

Panel A: Descriptive statistics

POLRISK 0.206 1.000

VARIABLES (1) (2) (3) (4) (5) (6) (7)

SIZE -0.0105*** -0.0103*** -0.00983*** -0.00995*** -0.0102*** -0.00985*** -0.0101***

Observations 2,694 2,694 2,686 2,686 2,686 2,686 2,686

INSTITUTION 0.0319** -0.0205

GOVACT -0.00012 0.0145***

DEMOCR -0.0045 0.0133

POLRISK 0.00674*** 0.00451** 0.00953*** 0.00550*** 0.00347 0.00479***

Observations 2,686 1,563 1,905 1,834 565 2,121

VARIABLES (1) (2)

POLRISK 0.0622*** 0.0602***

Observations 2,694 2,686

VARIABLES (1) (2) (3) (4) (5)

SIZE -0.0071*** -0.0042*** -0.0066*** -0.0075*** -0.0092**

Observations 158 158 158 158 158

Observations 2,686 2,686 2,686 2,686 2,686

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SIZE -0.0105* -0.0103* -0.00983* -0.00995* -0.0102* -0.00985* -0.0101***

POLRISK 0.00674* 0.00451 0.00953* 0.00550* 0.00347 0.00479***

POLRISK 0.0622* 0.0602*

SIZE -0.0071* -0.0042* -0.0066* -0.0075* -0.0092**