After completing this reading, you should be able to:

• Identify and explain the key channels through which geopolitical risk influences asset prices and financial stability and discuss policy measures to address potential consequences.
• Analyze how global geopolitical risk events affect countries, sectors, and asset classes differently, including their varying impacts on commodity importers and exporters.
• Assess the stock market responses to different domestic and global geopolitical risk events, including Russia’s invasion of Ukraine and the U.S.–China trade tensions, and explain the cross-border effects of these events.
• Evaluate the effects of geopolitical shocks on sovereign risk premiums.
• Explain how investors price geopolitical risk in equity and option markets, including changes in downside risk and tail-risk premiums.
• Describe the implications of geopolitical risk exposure for the resilience of banks and nonbank financial institutions, including effects on equity valuations, lending, and investment fund flows.

Introduction and Context

Geopolitical risks have emerged as a critical consideration for financial risk managers, particularly since 2022. These risks encompass potential adverse events such as wars, terrorist acts, and inter-state tensions that can disrupt international relations and economic stability. For FRM candidates, understanding the transmission mechanisms through which geopolitical events affect asset prices and financial stability is essential for effective risk identification, measurement, and management.

The relevance of this topic to risk management practice is multifaceted. Geopolitical risks can trigger abrupt asset price corrections, reverse capital flows, disrupt supply chains, and challenge the operational resilience of financial institutions. The interconnected nature of global financial markets means that geopolitical events in one region can rapidly transmit shocks to institutions and markets worldwide through trade and financial linkages.

Empirical evidence demonstrates that news-based measures of geopolitical risk events, countries’ military spending relative to GDP, and restrictions on cross-border trade and financial transactions have all increased significantly since 2022. A composite measure combining these indicators—the geoeconomic fragmentation index—has reached its highest level in several decades, underscoring the heightened importance of incorporating geopolitical risk into financial risk frameworks.

Key Channels of Geopolitical Risk Transmission

An increase in geopolitical risk affects prices of financial assets and threatens macrofinancial stability through two primary channels: the economic channel and the market sentiment channel.

The Economic Channel

The economic channel operates through several interconnected mechanisms:

Trade and financial restrictions: Geopolitically motivated restrictions on trade and financial transactions disrupt supply chains, reverse capital flows, or inflict adverse demand shocks on targeted economies. These disruptions directly affect the prices of both real and financial assets.

Policy response effects: Macroeconomic policy responses to geopolitical events—such as changes in growth and inflation—indirectly influence asset prices. Central banks may adjust monetary policy in response to inflationary pressures from supply disruptions, while fiscal authorities may increase spending for defense or economic support.

Physical damage and conflict: In cases of military conflicts, actual or expected damage to physical infrastructure, production facilities, and civilian populations reduces domestic and external demand, undermining investment and economic activity. This damage to productive capacity has lasting effects on asset valuations.

Sovereign risk amplification: Sovereign yield spreads and credit default swap (CDS) spreads may widen if geopolitical risks heighten fiscal sustainability concerns—for example, through increased military spending, greater borrowing needs, or output declines. This sovereign-bank nexus can amplify financial instability.

The Market Sentiment Channel

The market sentiment channel operates through investor psychology and risk perception. Increases in geopolitical risk raise macroeconomic and financial uncertainty even before any conflict or policy change materializes. This uncertainty affects asset prices by reducing investor confidence and increasing risk aversion.

Depressed asset valuations resulting from sentiment shifts increase liquidity and credit risks for both financial and nonfinancial institutions. Large and abrupt declines in asset prices can trigger margin and collateral calls, as well as redemption pressures on investment funds. These pressures may force asset fire sales and propagate contagion within the broader financial system, thereby heightening the risk of an adverse macrofinancial feedback loop.

Empirical analysis shows that both risk aversion and uncertainty increase after large geopolitical shocks, with the effect on uncertainty being more notable and persistent, particularly for global shocks. The Chicago Board Options Exchange Volatility Index (VIX) tends to spike following major domestic or global geopolitical events.

Summary: Transmission Mechanisms

$$ \begin{array}{l|l|l} \textbf{Channel} & \textbf{Mechanism} & \textbf{Asset Price Impact} \\ \hline \textbf{Economic} & {{\text{Trade restrictions,}\\ \text{financial sanctions,}\\ \text{supply chain disruption,}\\ \text{capital flow reversal,}\\ \text{physical damage}}} & {{\text{Stock price decline through}\\ \text{reduced cash flows;}\\ \text{sovereign spread widening;}\\ \text{commodity price increases}}} \\ \hline \textbf{Market Sentiment} & {{\text{Increased uncertainty,}\\ \text{reduced investor confidence,}\\ \text{elevated risk aversion}}} & {{\text{Higher discount rates,}\\ \text{volatility spikes,}\\ \text{flight-to-safety,}\\ \text{increased option premiums}}} \end{array} $$ 

Differential Impacts Across Countries, Sectors, and Asset Classes

The impact of geopolitical risks on asset prices varies significantly across asset classes, sectors, and countries. Understanding these heterogeneous effects is essential for portfolio risk management and stress testing.

Commodity Exporters versus Importers

A fundamental distinction exists between the effects on commodity-exporting and commodity-importing countries. Supply-chain disruptions caused by geopolitical events typically increase commodity prices while simultaneously depressing stock prices in economies reliant on imported commodities. This divergence creates both risks and opportunities for portfolio managers.

For commodity-importing countries, sovereign CDS spreads generally increase by more than 1 percent cumulatively in the week following major global geopolitical risk events. Currency depreciation accompanies this widening of the spread, particularly in commodity-importing emerging markets.

By contrast, commodity exporters typically experience declining sovereign CDS spreads and may see positive stock returns, as higher commodity prices benefit their corporate sectors and improve fiscal positions.

Sectoral Variation

Sector-specific impacts follow intuitive patterns based on exposure to geopolitical factors:

Benefiting Sectors:

• Energy sector: Typically benefits from geopolitical events that raise oil prices through supply disruption fears
• Defense and aerospace: Tend to outperform, reflecting anticipated increases in government military expenditure
• Alternative energy: May benefit from increased attention to energy security

Vulnerable Sectors:

• Consumer discretionary and retail: Often suffer from supply disruptions and higher input costs
• Utilities: Energy-dependent operations face cost pressures
• Sectors with extensive global supply chains: Face heightened vulnerability to trade restrictions
• Financial sector: Banks may experience negative impacts through credit deterioration and increased uncertainty

Advanced Economies versus Emerging Markets

International military conflicts have a significantly larger effect on the stock prices of firms in emerging market economies than on those in advanced economies. Empirical analysis demonstrates that such conflicts cause approximately a 5 percent decline in emerging market firm stock prices, substantially greater than the impact on advanced economy firms.

This differential reflects several factors:

1. Advanced economies generally have not experienced military conflict on their own soil in recent decades, avoiding significant physical destruction and economic damage
2. Their military and economic power often exceeds that of their counterpart nations in conflicts
3. Advanced economies—particularly traditional safe havens such as the United States, Germany, Japan, Switzerland, and the United Kingdom—benefit from flight-to-safety capital flows during periods of elevated geopolitical risk

Summary: Asset Class Response Patterns

$$ \begin{array}{l|l|l} \textbf{Asset Class} & \textbf{Typical Response} & \textbf{Key Moderating Factors} \\ \hline \text{Equities} & {{\text{Decline ~3% on average;}\\ \text{up to 9% for severe events}}} & {{\text{Sector exposure, country}\\ \text{involvement, trade linkages}}} \\ \hline \text{Sovereign CDS} & {{\text{Spreads widen, especially for}\\ \text{EM commodity importers}}} & {{\text{Fiscal buffers, reserve adequacy,}\\ \text{institutional quality}}} \\ \hline {{\text{Government}\\ \text{Bonds}}} & {{\text{Safe haven yields decline;}\\ \text{EM yields increase}}} & {{\text{Safe haven status, domestic}\\ \text{vs. foreign event}}}\\\hline \text{Commodities} & {{\text{Oil and gold prices generally}\\ \text{increase}}}& {{\text{Supply disruption risk,}\\ \text{safe haven demand}}} \end{array}$$

Stock Market Responses to Geopolitical Events

Analysis using panel vector autoregression models reveals that geopolitical risk shocks exert meaningful downward pressure on stock markets, with the magnitude depending on shock severity and whether shocks are global or country-specific.

Quantitative Estimates of Stock Price Impacts

Aggregate stock prices generally decline by approximately 0.3 percent in response to a typical country-specific geopolitical risk shock (scaled to two standard deviations), with effects persisting for at least two years. However, more severe shocks—those increasing the geopolitical risk index by at least two standard deviations above its mean—produce effects approximately seven times larger and are notably persistent.

Global geopolitical risk shocks, which affect international relations or economies at a broader scale, cause average stock price declines of approximately 1 percent that persist for about one quarter. Given that average three-month stock market returns across countries in the sample approximate 0.1 percent, a typical geopolitical shock has an impact roughly three times this benchmark, while a large shock produces effects approximately 20 times this benchmark.

Case Study: Russia’s 2022 Invasion of Ukraine

Russia’s invasion of Ukraine provides a comprehensive case study of geopolitical risk transmission:

Pre-invasion period: Media reports of Russian troop movements near the Ukrainian border beginning October 30, 2021, initiated a gradual decline in Russian equity markets.

Invasion impact: The military invasion on February 24, 2022, triggered a 33 percent single-day collapse in the Russian stock market, while trading on the Ukrainian exchange was suspended.

Spillover Effects:

• Defense sector stocks in other economies rose on expectations of increased military expenditure
• Energy sector firms benefited from surging oil prices on supply disruption fears
• Firms with direct revenue exposure to Russia or Ukraine experienced stock return declines of approximately 7 percentage points cumulatively within seven days
• Firms with subsidiaries in either country experienced average declines of 5 percentage points within one week

Portfolio Reallocation:

• The share of firms with subsidiaries in Russia declined from over 2 percent (2015–2021) to approximately 1.5 percent (2023)
• Subsidiary asset sizes halved from 0.3 percent to 0.14 percent of the parent company’s total assets
• However, some non-European countries increased their Russian exposure from relatively low initial levels

Case Study: U.S.–China Trade Tensions (2018–2024)

Trade tensions between the United States and China illustrate how geopolitical risk can manifest through economic policy actions rather than military conflict:

Impact of U.S. Tariff Announcements on Chinese Firms:

• Stock prices declined by nearly 4 percent on average, affecting both directly targeted sectors and others
• Particularly significant given average pre-tariff stock returns of only 0.1 percent
• The May 6, 2019 announcement (tariffs on $200 billion of Chinese products) caused approximately 8 percent average declines

Spillback Effects on U.S. Firms:

• S. firm stock prices declined by 1.3 percent on average following U.S. tariff announcements
• Reflects anticipated retaliation, supply chain interconnectedness, aggregate demand impacts, and uncertainty

Retaliatory Tariff Effects:

• China’s August 23, 2019 retaliatory tariff announcement caused U.S. firm stocks to fall 6–1.8 percent and Chinese firm stocks to decline 0.3–0.7 percent

Cross-Border Transmission Effects

Geopolitical risk events transcend national borders through multiple channels:

Trade linkages: When a country’s main trading partner becomes involved in a major geopolitical risk event, stock returns for the country’s firms decline by approximately 1 percentage point on average. This impact amplifies to 2.5 percentage points when the trading partner is involved in a military conflict.

Revenue and subsidiary exposure: Firms generating significant proportions of revenues from, or maintaining subsidiaries or shareholding companies in, countries affected by geopolitical events experience additional stock price declines of 0.1–0.25 percentage points, controlling for macro and sectoral effects. For emerging market firms, exposure through shareholding companies appears more important than subsidiary presence.

Effects of Geopolitical Shocks on Sovereign Risk Premiums

Geopolitical risks influence sovereign risk through multiple mechanisms. Higher military spending weighs on government fiscal outlooks, while deteriorating economic activity pushes up public-debt-to-GDP ratios and raises fiscal sustainability concerns. The interconnectedness of sovereign and financial sector balance sheets amplifies these effects, creating potential for adverse feedback loops.

Quantitative Impact on CDS Spreads

Sovereign CDS spreads widen significantly after major geopolitical risk events, with particularly pronounced effects during military conflicts:

• Advanced economies: CDS spreads widen by approximately 40 basis points within one month of involvement in a major international military conflict
• Emerging market economies: CDS spreads widen by approximately 180 basis points under similar circumstances

Foreign geopolitical risk events also affect sovereign risk premiums through trade linkages. When a country’s key trading partner becomes involved in an international military conflict, the country’s own CDS spreads widen, reflecting negative impacts on economic activity and upward pressures on inflation from supply disruptions.

Amplifying Factors

Economies with smaller fiscal and international reserve buffers or poorer institutional quality exhibit greater vulnerability to geopolitical shocks:

High public debt: When key trading partners experience international military conflicts, sovereign risk premiums increase more substantially in emerging markets, characterized by high public-debt-to-GDP ratios (above the sample median).

International reserve adequacy: Economies with international reserve adequacy ratios below the sample median experience CDS premium increases approximately 100 basis points larger than those with adequate reserves.

Institutional quality: Economies with institutional quality below the sample median face CDS premium increases approximately 120 basis points larger than their better-governed counterparts.

Safe Haven Effects

Long-term sovereign yields in traditional safe haven countries—Germany, Japan, Switzerland, the United Kingdom, and the United States—tend to decline following major geopolitical risk events, reflecting flight-to-safety capital flows. This pattern is particularly pronounced during major foreign geopolitical events, when yields rise sharply in other advanced economies but remain stable or decline in safe-haven countries.

By contrast, emerging market sovereign yields typically increase following both domestic and foreign geopolitical events.

Exam Focus: The sovereign-bank nexus is a critical concept. Rising sovereign risk premiums can adversely affect banks’ balance sheets through their holdings of government securities, while weakened banks may require government support, further straining sovereign creditworthiness. This feedback loop is particularly relevant in economies with less well-capitalized banking systems and higher fiscal vulnerabilities.

Pricing of Geopolitical Risk in Equity and Option Markets

The impact of geopolitical risk shocks on asset prices depends critically on the extent to which investors price these risks in advance. Asset pricing theory implies that investors should require positive risk premiums to hold stocks likely to lose value when geopolitical risks materialize, while assets that hedge against such risks should command lower expected returns.

Geopolitical Risk Beta

The sensitivity of stock returns to geopolitical risk shocks after controlling for market factors—termed the geopolitical risk (GPR) beta—exhibits substantial cross-sectional variation. The distribution of GPR betas is nearly symmetric, with many stocks showing both positive and negative sensitivities to geopolitical shocks.

Sectoral patterns in GPR betas align with economic intuition:

• High (positive) GPR beta sectors: Energy and defense—their values tend to rise following geopolitical shocks as energy prices increase and military expenditure rises
• Low (negative) GPR beta sectors: Consumer goods—consistent with reduced consumer demand during periods of elevated geopolitical risk

Risk Premium Dynamics

Empirical analysis reveals that investors factor geopolitical risk into equity valuations, but the nature of this pricing has evolved over time:

2012–2021 Period:

• Cross-sectional analysis showed a statistically significant and negative premium associated with geopolitical risk
• Stocks acting as hedges against geopolitical risk (positive GPR beta) offered lower expected returns
• Stocks vulnerable to such risks (negative GPR beta) offered higher expected returns to compensate investors

Post-2022 Period (After Russia’s Invasion):

• The GPR premium turned positive
• Investors began favoring stocks that serve as hedges against geopolitical risks, accepting lower returns for this hedging benefit
• A strategy buying high GPR beta stocks and selling low GPR beta stocks generated negative monthly returns of approximately 5 percent during 2012–2021 but positive returns of roughly 1.1 percent after 2022

Options Market Evidence

Options markets provide direct evidence of geopolitical risk pricing through the cost of protection against downside risks. Out-of-the-money put options measure the premium investors pay to protect against tail risks—extreme negative outcomes that are relatively unlikely but potentially severe.

Russia-Ukraine Conflict:

• Premiums for both downside risk protection and tail risk protection increased moderately before the invasion but surged notably around the event
• Premiums increased most for options on Russian firms, but also rose significantly for options on European firms
• Energy sector option premiums remained stable (sector benefiting from rising energy prices)
• Options on consumer goods firms and those with high exposure to Russia/Ukraine faced higher premiums

U.S.–China Trade Tensions:

• Following the 2018–2019 tariff announcements, option premiums for protecting against downside and tail risks increased for both Chinese and U.S. firms
• Firms in other countries showed no significant premium increase
• Tail risk premiums increased more prominently than general downside risk premiums, indicating trade tensions primarily affected perceptions of extreme outcomes

Implications for Banks and Nonbank Financial Institutions

Banks and nonbank financial institutions face elevated market, liquidity, and credit risks during geopolitical events. Changes in asset prices—particularly rapid selloffs—cause fluctuations in the values of financial assets on institutional balance sheets, affecting risk-taking capacity and funding conditions and potentially triggering adverse macrofinancial feedback loops.

Exposure Quantification

Cross-border bank claims and liabilities involving countries affected by major geopolitical risk events are substantial:

• Approximately 8 percent of total cross-border bank claims as of the second half of 2024
• Approximately 10 percent of total cross-border liabilities
• This exposure has increased considerably—the average share was approximately 3 percent from 2000 to early 2024

Investment fund exposure is also significant:

• The share of equity fund holdings in assets domiciled in countries experiencing major geopolitical events reached 13 percent of fund assets in 2024
• Most banking sectors and investment funds hold some assets in countries exposed to major geopolitical risk events

Impact on Bank Stability and Lending

Major geopolitical risk events adversely affect bank stability and lending, with more pronounced effects in emerging market economies:

Equity effects: Bank equity tends to decline when a bank’s home country or key foreign counterparts are involved in international military conflicts. This equity erosion contributes to reduced loan growth.

Transmission Mechanisms:

• Deterioration of borrower creditworthiness after domestic geopolitical events leads banks to cut lending amid heightened uncertainty
• Foreign geopolitical events can cause cross-border claims to lose value
• Rolling over foreign wholesale debt becomes more difficult when events affect key counterparts

Credit quality: Empirical results confirm increases in borrowing costs and nonperforming loans following major geopolitical events.

Investment Fund Performance and Flows

Investment funds with significant exposure to countries involved in geopolitical events, particularly military conflicts, experience lower returns and outflows:

Bond funds: Funds with 10 percent exposure to conflict-affected countries subsequently experienced a 1.0 percentage point decline in returns and a 2.3 percentage point decline in flows.

Equity funds: Experienced smaller but meaningful impacts—approximately 0.2 percentage point return decreases and 0.3 percentage point flow declines.

Russia-Ukraine Case:

• Investment funds with 10 percent direct exposure to Russian or Ukrainian assets experienced approximately 6 percent cumulative return declines within one week
• Cumulative flow decreases of 8 percent occurred over the subsequent six months
• Funds also reduced indirect exposures by decreasing holdings of third-country firms with high revenue or subsidiary exposures to Russia or Ukraine

Portfolio Reallocation

Financial institutions actively rebalance portfolios in response to geopolitical events:

• Following Russia’s invasion of Ukraine, cross-border banking claims on Russia and Ukraine fell significantly
• Investment funds reduced direct exposures to both countries by approximately 60 percent
• This reallocation reflects risk management responses but can contribute to market stress during transitions

Policy Recommendations and Risk Management Implications

Institutional Risk Management

1. Resource allocation: Financial institutions should devote adequate resources to identifying, quantifying, and managing geopolitical risks. This includes developing expertise in geopolitical analysis and integrating such analysis into risk management frameworks.
2. Scenario analysis and stress testing: Institutions should incorporate geopolitical risk scenarios into stress testing frameworks, considering interactions between geopolitical risks and traditional market, credit, and liquidity risks. Given the inherent uncertainty of geopolitical events, a range of scenarios should be evaluated.
3. Capital and liquidity buffers: Buffers should be calibrated to absorb extreme but plausible losses associated with geopolitical risk materialization. The heterogeneous effects across sectors and countries suggest that buffer requirements may need to reflect institution-specific exposures.
4. Exposure monitoring: Institutions should maintain current assessments of both direct exposures (claims on affected countries) and indirect exposures (through trade partners, subsidiaries, and revenue sources). The cross-border transmission evidence emphasizes the importance of monitoring second-order connections.

Supervisory Considerations

1. 1. Country-specific assessment: Policymakers should consider country-specific geopolitical risks in oversight of financial institutions. The differential vulnerability of emerging markets and commodity importers suggests the need for tailored supervisory approaches.
   2. Data collection: Supervisors should collect data on financial institutions’ direct and indirect exposures to geopolitical risk to support scenario analysis and systemic risk assessment.
   3. Nonbank financial intermediary oversight: Policymakers should ensure appropriate tools exist to address financial stability consequences from stress in nonbank financial intermediaries, including requiring liquidity management tools by open-end funds.

 Macroprudential Measures

1. Financial market development: Emerging market and developing economies should continue efforts to deepen financial markets, accompanied by robust regulatory frameworks. Deeper derivatives markets can support hedging against geopolitical risks.
2. Reserve adequacy: Economies reliant on external financing should maintain adequate international reserves to cushion adverse geopolitical shocks and manage capital flow volatility.
3. Fiscal space: Fiscal vulnerabilities should be contained to limit the amplifying effects of high public debt on sovereign borrowing costs during geopolitical stress.
4. Crisis preparedness: Crisis preparedness and management frameworks should be strengthened to address potential instability arising from geopolitical tension escalation.

Common Exam Pitfalls

• Confusing the economic channel (real effects on trade, production, and cash flows) with the market sentiment channel (uncertainty and risk aversion effects on discount rates and investor behavior)
• Overlooking the distinction between commodity exporters and importers when analyzing differential country impacts
• Failing to recognize that advanced economy safe havens experience declining yields during geopolitical stress, opposite to emerging market patterns
• Ignoring cross-border transmission effects through trade linkages, revenue exposure, and subsidiary presence
• Misunderstanding the GPR beta concept—positive beta stocks hedge geopolitical risk (energy, defense) while negative beta stocks are vulnerable (consumer goods)
• Underestimating the importance of fiscal buffers, reserve adequacy, and institutional quality as moderating factors for sovereign risk premium responses

Key Terms Summary

Geopolitical Risk: Potential adverse events such as wars, terrorist acts, and inter-state tensions that can disrupt international relations and economic stability.

Geoeconomic Fragmentation Index: A composite measure combining restrictions on cross-border trade, investments, and financial transactions; military conflicts; indicators of diplomatic tensions; and migration policies.

GPR Beta: The sensitivity of stock returns to geopolitical risk shocks after controlling for market factors.

Downside Tail Risk: The risk of extreme negative realized future asset returns, typically measured at the 10th percentile of the return distribution.

Sovereign-Bank Nexus: The interconnection between sovereign creditworthiness and financial sector health, where sovereign stress can weaken banks, and bank weakness can strain sovereigns.

Flight-to-Safety: Investor behavior during stress periods characterized by shifting capital from risky assets to perceived safe havens, typically high-quality sovereign bonds of advanced economies.

Macrofinancial Feedback Loop: A self-reinforcing cycle where financial sector stress reduces lending and economic activity, which further weakens financial institutions.

Question

A stress testing team at a large bank is designing a “geopolitical stagflation” scenario. They are estimating the impact on the bank’s capital adequacy. In this scenario, which combination of factors would pose the most severe threat to the bank’s equity valuation and capital ratios?

1. Falling interest rates, rising credit losses, and appreciation of the domestic currency.
2. Rising interest rates, rising credit losses, and a decline in the fair value of fixed-income securities.
3. Rising interest rates, falling credit losses, and rising net interest margins.
4. Stable interest rates, stable credit losses, and a decline in operational costs.

Correct Answer: B

 A geopolitical supply shock (e.g., oil price spike) often leads to stagflation: high inflation requiring higher interest rates, combined with low growth causing credit defaults. Banks suffer a “double hit”:

1. Credit Risk: Borrowers default due to economic slowdown (rising credit losses).
2. Market Risk: Higher rates reduce the fair value of fixed-income assets held on the balance sheet (unrealized losses). This combination erodes capital buffers most severely.

A is incorrect. Falling rates would generally boost the value of fixed-income holdings, providing a buffer against credit losses.

C is incorrect. This is a positive scenario for banks (higher margins, low defaults).

D is incorrect. This is a benign scenario.

Things to Remember:

• Geopolitical stagflation challenges the traditional diversification benefit between bonds and equities (both may fall).
• Banks must assess “interest rate risk in the banking book” (IRRBB) alongside credit risk in these scenarios.
• Declining equity valuations of banks increase their cost of capital, making it harder to raise funds to support lending.