With capital accounts more open and technological innovations changing the pace of transactions, financial markets are increasingly integrated. Trading occurs twenty-four hours a day throughout the globe. Fluctuations in one market can affect the behavior of markets across borders. A glance at the worldwide financial news media illustrates this phenomenon: Trading on the New York Stock exchange conditions trading in Tokyo, which, in turn, influences market activity in London, which then affects New York. More spectacularly (and more destructively), the Asian crisis of 1997–98 quickly spread to markets in other developing countries, a process of contagion that has been widely studied in the finance and economic literatures.

As the previous chapter demonstrated, political events do, under certain conditions, affect market performance in domestic equities and bond markets. In a world of integrated financial markets, those political events may touch off reactions in markets in other countries. We investigate this possibility in this chapter. We contend that the configuration of political and economic institutions at both the domestic and international levels can mitigate the effect of cross-border political shocks. To evaluate the argument, we adopt a two-stage research design. Drawing on arbitrage pricing theory, we first measure the size of foreign political shocks. In the second stage, we test alternative explanations for the variation in the size of those shocks. Consistent with the findings in Chapter 3, the results indicate that political events with a predictable outcome have less impact on markets (both foreign and domestic) than unpredictable events.