Hedging Political Risk in International Equity Portfolios
60 Pages Posted: 24 Jul 2021 Last revised: 28 Mar 2023
Date Written: December 1, 2022
Abstract
Internationally diversified portfolios carry sizeable political risk premia and are exposed to tail risk. We develop a portfolio selection model to obtain political efficient frontiers and hedge political risk and devise an asymptotic inference test to compare portfolio performance. Empirical tests on a sample of 42 developed and emerging markets document that performance gains from international diversification persist when political risk is hedged, but screening ex-ante politically risky markets is inefficient. Political hedging is not subsumed by currency hedging, and the diversification gains of politically hedged portfolios increase for long-horizon investors. We also show that hedging political risk induces equity home bias. Our findings hold for US, Eurozone, and Japanese investors.
Keywords: Hedging, political risk, international diversification, equities markets, conditional Value-at-Risk, portfolio optimization.
JEL Classification: C12, C13, C61, F21, F30, G11.
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