Geopolitical Risk and Investment

Abstract

Using a news-based index of geopolitical risk (GPR), we document a strong negative relationship between firm-level corporate investment and GPR. When the GPR index doubles, investment rate in the next quarter declines by 14% of its sample mean. The effect is more pronounced for firms with more irreversible investment or higher market power, confirming the real options theory. However, the effect is less significant for firms with a stronger ability to substitute labor for capital or with a higher labor-to-capital ratio, supporting the convex return theory. Furthermore, the impact of GPR on investment varies across geopolitically-sensitive sectors. It is stronger for firms in the tourism and its related sectors and is weaker for firms in the defense sector. Overall, our results suggest that the real options channel dominates the Oi-Hartman-Abel effect in driving the negative GPR-investment relationship.

Keywords: geopolitical risk, uncertainty, corporate investment, irreversibility, convexity

JEL Classification: G11, G31, E22