A Unified Financial Index for Geopolitical and Environmental Risks: Construction, Risk Management, and Derivative Applications

Abstract

Geopolitical conflicts and climate shocks are among the most consequential threats to global financial stability, yet financial markets still lack a unified metric to capture their joint risk. Recent disruptions-from the COVID-19 pandemic to the Russia-Ukraine war-have revealed how deeply these risks are embedded in asset price dynamics. While prior research has examined geopolitical and climate policy uncertainty in isolation, few efforts have integrated them into a composite, marketrelevant index that reflects their joint systemic impact. This paper introduces the Global Geopolitical and Environmental Risk Index (GGERI)-a unified, dollar-denominated index that quantifies the compounded financial risk posed by geopolitical and climate-related uncertainty.Using daily data from the Geopolitical Risk Index (GPR) and the Climate Policy Uncertainty Index (CUPI), we construct GGERI via a five-step methodology involving log-return transformation, standardization, equal-weighted aggregation, and rescaling. The resulting index is evaluated through tail-risk metrics, ARFIMA-FIGARCH modeling, Hill estimation, and systemic spillover analysis. Robust regressions quantify the relative contribution of GPR and CUPI to GGERI dynamics.Empirical results show that GGERI exhibits heavy-tailed behavior and extreme long memory in volatility, with persistent reactions to joint shocks. CUPI exerts a stronger influence on GGERI returns than GPR, reflecting the market's heightened sensitivity to regulatory ambiguity. Tail-risk measures reveal significant conditional vulnerability, especially under simultaneous geopolitical and climate distress.The GGERI index offers a parsimonious and interpretable benchmark for systemic risk, supporting applications in risk management, portfolio hedging, and macroprudential surveillance. Our findings encourage the design of derivatives (e.g., options) based on GGERI, enabling market participants to hedge dual tail risks more effectively. This work contributes to the broader literature by integrating macro-risk signals into actionable financial instruments.

Keywords: Geopolitical Risk, Climate Policy Uncertainty, GGERI Index, Tail Risk Spillovers, Systemic Financial Risk