Geopolitical threats, equity returns, and optimal hedging

• Published in: International review of financial analysis 2023-11, Vol.90, p.102835, Article 102835
• Main Authors: Ali, Syed Riaz Mahmood, Anik, Kaysul Islam, Hasan, Mohammad Nurul, Kamal, Md Rajib
• Format: Article
• Language: English
• Subjects: Asset returns; Exchange-traded fund (ETF); Geopolitical threats; Hedging; Safe heaven
• ISSN: 1057-5219; 1873-8079
• DOI: 10.1016/j.irfa.2023.102835

In this paper, we demonstrate that the U.S. equity market and a few specific sectors produce significantly positive returns during high geopolitical threats, even with the presence of standard controls, whereas other major markets around the world fail to exhibit such results. We use the geopolitical threats (GPT) index of Caldara and Iacoviello (2022). We extend our study by examining the equity returns during extremely high geopolitical threats and find the results significantly positive for the U.S. equity market and two specific sectors- information technology and financials. The results of our investigation are likewise supported by the lead-lag regression and the Markov regime-switching model. Our results are robust in the presence of various alternative measures of market uncertainty indices, for instance, economic policy uncertainty, economic uncertainty, macroeconomic uncertainty etc., on a daily basis. However, the return on equity was not robust when conditional volatility and monthly frequency were considered. We also investigate and find the optimal hedging implications for investors during the presence of geopolitical threats. We find a considerable hedge alternative between the US market and gold and further explore how Geopolitical threats affect Gold and different US sectoral Exchange-traded funds (ETFs). •The U.S. equity market produces significantly positive returns during high geopolitical threats.•Two industries—finance, and information technology—do considerably better than the other sectors.•The results are robust in the presence of alternative measures of market uncertainty indices.•Geopolitical Threat changes impact the optical hedge ratios for a few asset pairs.