Geopolitical Risk, Financial Slack and Capital Investments

Abstract

A central prediction of the classical real options framework is that the value of delaying investments under uncertainty increases in the degree of asset irreversibility. We confirm this using a measure of geopolitical uncertainty developed by Caldara and Iacoviello (2018) that is uncorrelated with concurrent demand. A novel finding in our study is the dependent nature of investment irreversibility and uncertainty on financial slack – without sufficient slack, firms are unable to take advantage of delaying investments when faced with uncertainty shocks. Our findings explain the paradoxical result that firms with more cash holdings cut investments to a greater degree during times of high uncertainty.

Keywords: geopolitical risks, geopolitical uncertainty, firm investment, threats, uncertainty, liquidity, cash

JEL Classification: D80, G31, H56