Financial Management Perspective

Financial Management Perspective

Investigating the Effects of Political Stability on Stock Market Returns and Volatility: The Moderating Role of Foreign Direct Investment

Document Type : Original Article

Authors
mohammad ahmadi 1
ehsan taieby 2
mohammad ebrahim Aghababaei 2
1 .Sc. Student, Faculty of Financial Sciences, Kharazmi University, Tehran, Iran
2 Faculty member, Kharazmi Faculty of Financial Sciences, Tehran
10.48308/jfmp.2026.245003.1605
Abstract
Introduction: Financial markets constitute one of the most important pillars of an economic system and are highly influenced by political and institutional conditions. In developing economies, particularly in Iran, political instability can significantly affect investors’ behavior, stock market returns, and volatility by increasing uncertainty and perceived risk. Political uncertainty often weakens investor confidence, disrupts capital allocation, and amplifies market fluctuations. In contrast, foreign direct investment (FDI), as a major channel for capital inflows, technology transfer, and confidence building, may play a moderating role in mitigating the adverse effects of political instability on financial markets.

The main objective of this study is to examine the impact of political stability on stock market returns and volatility in Iran and to analyze the moderating role of foreign direct investment in this relationship. Specifically, the study aims to investigate both the short-run and long-run effects of political stability on stock market performance and to assess whether FDI strengthens the positive influence of political stability on returns while reducing market volatility.

Methods: This research is applied in terms of objective and quantitative–empirical in nature. Monthly time-series data covering the period from 2015 to 2024 are used to analyze the relationships among political stability, foreign direct investment, and stock market returns in Iran. To address differences in data frequency, appropriate interpolation techniques were employed. The Autoregressive Distributed Lag (ARDL) model was applied to examine both short-run dynamics and long-run equilibrium relationships among the variables. Furthermore, to analyze stock market volatility and the asymmetric effects of political shocks, Generalized Autoregressive Conditional Heteroskedasticity (GARCH) and Exponential GARCH (EGARCH) models were utilized. These models allow for capturing volatility clustering, persistence, and asymmetry in financial time series. In addition, an interaction term between political stability and foreign direct investment was incorporated into the models to explicitly assess the moderating role of FDI in the relationship between political stability and stock market performance.

Results and discussion: The results indicate that the effect of political stability on stock market performance is neither uniform nor straightforward, but rather depends on institutional and economic conditions. The results of the estimated models show that the direct effect of political stability on stock market returns is negative and statistically significant, whereas, in the presence of foreign direct investment, political stability has a positive and statistically significant effect on stock market returns and simultaneously contributes to reducing market volatility. This finding indicates that political stability alone does not necessarily lead to higher stock market returns; rather, its effect on returns depends on the level of foreign direct investment. Furthermore, foreign direct investment, both independently and particularly through its interaction with political stability, plays a moderating role in mitigating the adverse effects of political instability. Regarding volatility, the results of the GARCH and EGARCH models indicate that the direct effect of political stability on stock market volatility is positive and statistically significant; however, the coefficient of the interaction term between political stability and foreign direct investment is negative and statistically significant, indicating that at higher levels of foreign direct investment, the effect of political stability on volatility is moderated and shifts toward reducing stock market volatility. In addition, the results of the volatility models confirm the presence of volatility clustering and long memory in the conditional variance of market returns, while the EGARCH model indicates that market volatility responds more strongly and persistently to negative political shocks than to positive shocks.

Overall, the findings of this study suggest that political stability and foreign direct investment are two complementary and mutually reinforcing factors in explaining the returns and stability of Iran’s stock market. Political stability provides the necessary foundation for the transmission of the positive effects of foreign investment to the capital market, while foreign direct investment, by strengthening confidence and reducing uncertainty, moderates the intensity of the impact of political shocks on the stock market. These findings can offer a practical basis for economic policymakers and investors in developing economies, particularly in countries with institutional structures similar to that of Iran.

Conclusions: Overall, the results of this study indicate that political stability and foreign direct investment are key determinants of stock market performance and stability in Iran. Policies aimed at enhancing political stability, reducing institutional uncertainty, and creating a favorable environment for attracting foreign direct investment can significantly improve stock market efficiency, reduce investment risk, and strengthen investor confidence.
Keywords
Political Stability
Stock Market Returns
Stock Market Price Volatility
Foreign Direct Investment
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