| Abstract : | The goal of this paper is to implement a new measure of systemic risk for each country separately and based on that to design an investment strategy that exploits this measure. Firstly in order to extract the proposed measure I modify the Berger and Pukthuanthong (2011) measure of systemic risk. Berger and Pukthuanthong define their risk measure as the average loading on the world factor across countries at a point in time. From my side I define my measure of systemic risk as the average of loadings on the country factor (first principal component) across sectors at each point in time. The difference is that Berger and Pukthuanthong operate in a global environment and identify a common world factor, whereas I use the same framework but at a domestic level and I identify a common country factor. To extract this common country factor I conduct principal component analysis on the returns of domestic industry sectors. The country factor is the first principal component. Loadings on the first principal component reflect the exposures of the returns of each domestic sector to the common country factor. If exposures to the common country factor are high then we conclude that systemic risk is high. Since I have calculated the systemic risk for all countries of my survey, I create country portfolios that exploit the systemic risk. Then I examine several strategies such as long positions on portfolios of countries with the lower systemic risk and/or short positions on portfolios of countries with the higher systemic risk. I find evidence that a long position on the portfolio consisting of countries with the lower systemic risk outperforms in relation to benchmark portfolios and provides statistically significant abnormal returns.
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