Viewpoint: Geopolitical Risk—Analyzing the Age of Uncertainty
In Short
By Matthew Lightwood, Ph.D. at Conning
Geopolitical risk has regained prominence since the Russian invasion of Ukraine, prompting a need for a better under- standing of its impact on financial markets.
Despite challenges in measuring and quantifying geopoliti- cal risk, initiatives like the Bank of England’s systemic risk survey and the GPR Index are a good basis for more robust analysis.
Regression analysis reveals mixed findings on the relation- ship between geopolitical risk and financial market variables; however, it still suggests that forecasters and analysts may be wise to consider geopolitical risks in their work.
Surprisingly, heightened geopolitical risk has not necessarily led to reduced asset returns in the last 40 years, challenging conventional assumptions.
Introduction
The Russian invasion of Ukraine and the global fallout in its af- termath have once again thrust geopolitical risk to the forefront of risk managers’ minds. However, even with the awareness that geopolitical risk has increased in recent years, few are familiar with the data and tools that are available to investigate that risk’s effects on financial markets from a solid quantitative basis. In this whitepaper, we look at the importance of geopolitical risk, present recent developments in its measurement, and investi- gate the extent that geopolitical shocks affect financial markets.
What Is Geopolitical Risk and Why Does It Matter?
Geopolitical risk refers to the potential impact of global political and strategic factors and events on the stability and security of nations, regions, and the world at large. These risks arise from the interactions and conflicts between different countries, gov- ernments, and political entities, often influencing international re- lations and shaping the geopolitical landscape. Geopolitical risk encompasses a broad range of elements, including territorial disputes, military tensions, trade disputes, political instability, and ideological conflicts, including terrorist attacks. It is a highly dy- namic and multifaceted concept that we would expect to have sig- nificant implications for economic activity and financial markets.
As risk managers, investors, and analysts, we care about geopo- litical risk because of its ability to create uncertainty and unpre- dictability. Changes in government policies, diplomatic relations, or the outbreak of conflicts can disrupt supply chains, impact in- vestmentdecisions,andleadtofluctuationsincommodityprices. Additionally, geopolitical risk can contribute to the escalation of regionalorglobaltensions,potentiallyleadingtomilitaryconfron- tations or the imposition of sanctions. Geopolitical risk analysis assesses the potential impact of political events on the global economy,andunderstandingandmanagingthisriskiscrucial for businesses, investors, and policymakers wishing to mitigate its potentially negative consequences. However, it can be a difficult effect to measure and hence analyze in an unbiased way, but developmentshavebeenmadeinthisareawhichwewilldiscuss in the next section
