I will discuss two lines of research from the last five years that develop theoretically rigorous and empirically relevant models documenting the effects of political risk on financial markets and helping manage this risk in international portfolios. One line of research identified a strong factor structure in country political ratings, uncovering systematic variations in global political risk (P-factor). The P-factor commands a significant risk premium of 4.5% per annum with a Sharpe ratio of 0.7. It is not spanned by existing asset pricing factors, manifests across all asset classes, and relates to systematic variations in expected global growth and aggregate volatility. It is an “everywhere” factor in the sense of Asness-Moskowitz-Pedersen (Journal of Finance, 2013). This finding serves as the starting point for showing that diversified international portfolios do not diversify away political risk. We obtain efficient frontiers with and without hedging political risk using a portfolio selection model for skewed distributions and develop a new asymptotic inference test to compare portfolio performance. Politically hedged portfolios outperform a broad market index and the equally weighted portfolio. Hedging political risk induces equity home bias but does not fully explain the puzzle. Still, our work is not yet done, and we investigate the aggregate confusion among various popular political risk measures. Most (but not all) measures appear priced in the markets, and the risk premia are statistically indistinguishable. However, the political betas vary significantly, raising the question of how to hedge political risk under measurement ambiguity. We develop hedging models using robust optimization and show that zero-beta portfolios remain hedged in- and out-of- sample.

References:

V. D. Gala, G. Pagliardi, and S. A. Zenios (2023) Global political risk and international stock returns. Journal of Empirical Finance, 72:78–102.

V. D. Gala, G. Pagliardi, I. Shaliastovich, and S. A. Zenios (2024) Political risk everywhere. Working paper, available at SSRN, BI Norwegian Business School.

G. Pagliardi, S. Lotfi, E. Paparoditis, and S.A. Zenios, Hedging political risk in international equity portfolios, European Journal of Operational Research, 322:629-646, 2025