Geopolitical Threat, Market Capitalization, and Portfolio Return

Abstract

In this paper, we validate that in the US equity market, the large and prime cap portfolios can generate significantly positive returns against geopolitical threats, whereas other medium and small cap portfolios fail to exhibit such results. The results of our investigation are equally supported by the Markov regime-switching model where we find that portfolio returns perform better against geopolitical threats during high-volatility regimes. Additionally, we demonstrate that geopolitical threat has a significant impact on the conditional volatility of large and prime cap portfolios. However, the monthly impact and lag effect of geopolitical threat is not visible in our results indicating that investors adjust their portfolios instantly against geopolitical threat. Our findings are robust in the presence of various alternative measures of market uncertainties, for example, economic policy uncertainty, economic uncertainty, VIX, etc. We also conduct a series of out-of-sample regressions to confirm our results. Finally, we report a few trading strategies using geopolitical threats.

Keywords: Geopolitical Threats, Portfolio Returns, Hedging, Safe Heaven, Conditional Volatility