Measuring and Hedging Geopolitical Risk

27 Pages Posted: 29 Oct 2020

See all articles by Robert F. Engle

Robert F. Engle

New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER); New York University (NYU) - Volatility and Risk Institute

Susana Campos-Martins

University of Oxford - Nuffield College

Date Written: September 1, 2020

Abstract

Geopolitical events can impact volatilities of all assets, asset classes, sectors and countries. It is shown that innovations to volatilities are correlated across assets and therefore can be used to measure and hedge geopolitical risk. We introduce a definition of geopolitical risk which is based on volatility shocks to a wide range of financial market prices. To measure geopolitical risk, we propose a statistical model for the magnitude of the common volatility shocks. Accordingly, a test and estimation methods are developed and studied using both empirical and simulated data. We provide a novel explanation for why idiosyncratic volatilities comove based on a new way to formulate multiplicative factors. Finally, we propose a new criterion for portfolio optimality which is intended to reduce the exposure to geopolitical risk.

Keywords: ARCH, GARCH, Multivariate Volatility Models, Geopolitical Risk, Tail Risk, Tail Events, EM Algorithm, Hedging Geopolitical Risk, Country Risk Factors, MSCI Indices

JEL Classification: G150, G110, G170, F30, C58

Suggested Citation

Engle, Robert F. and Campos-Martins, Susana, Measuring and Hedging Geopolitical Risk (September 1, 2020). NYU Stern School of Business Forthcoming, Available at SSRN: https://ssrn.com/abstract=3685213 or http://dx.doi.org/10.2139/ssrn.3685213

Robert F. Engle (Contact Author)

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

New York University (NYU) - Volatility and Risk Institute ( email )

44 West 4th Street
New York, NY 10012
United States

Susana Campos-Martins

University of Oxford - Nuffield College ( email )

Oxford
United Kingdom

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