Can fear beat hope? A story of GARCH-in-Mean-Level effects for Emerging Market Country Risks

Upon winning the 2002 presidential elections, event that considerably increased the Brazilian country risk levels and volatility, Lula celebrated by declaring: “hope has beaten fear”. Extending Une and Portugal (2004), the aim of this paper is twofold: to empirically test the interrelations between country risk conditional mean (“hope”) and conditional variance (“fear”) and cast light on the role of country risk stability in the conduction of macroeconomic policies in developing small open economies. We compare the forecasting performance of various alternative GARCH-in-Mean-Level models for n-step conditional volatility point forecasts of the Brazilian country risk estimated for the period May 1994 - February 2005. The results support the idea that both hope and fear play important roles in the Brazilian case and confirms that hope and fear act in the same direction.