Geopolitical risk has become an increasingly important component of risk analysis. It is broadly defined as the exposure of one or more countries to political actions in other countries. Clearly events such as the UK Brexit vote in 2016 are considered geopolitical events. However many other events such as military or terrorist actions and central bank or regulatory actions can also be interpreted as geopolitical events. Even local financial events, cyber-attacks, trade wars, and climate change can have global financial impacts.
Geopolitical events can impact the volatility of all assets, asset classes, sectors, and countries. It is shown that innovations to volatility are correlated across assets and therefore can be used to measure and hedge geopolitical risk.
Geopolitical risk is often the explanation for weak investment results. Conventional Markowitz style portfolios are predicted to have low volatility but they may be very sensitive to volatility shocks. Thus, assets that are not sensitive to volatility shocks are likely to be attractive in a portfolio because they diversify geopolitical risk.
Hedging geopolitical risk has practical benefits to investors and firms. As investors look beyond their home market for the global investment opportunity set, it matters from where risk is coming in to where it spreads. However, risk arising from a geopolitical event is potentially very dangerous to investors since a single event can result in increased volatility for all assets in a portfolio or all lines of business for a conglomerate firm. Conventional diversification does not reduce its impact.
The Geopolitical Risk section of V-Lab attempts to provide a means of properly identifying and quantifying geopolitical risk.