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.
Join the NIPE seminars Google calendar: https://bit.ly/2LKkPyV
Looking forward to your attendance!