Political risk in internationally diversified portfolios
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We show that internationally diversified portfolios carry sizeable political risk premia. We propose a mean to conditional Value-at-Risk (MTC) optimization model for skewed frontiers to hedge global political risk, develop an inference test, and establish that diversification benefits persist with political risk hedging. The hedged international portfolio of US investors with no short sales outperforms the index in both MTC and Sharpe ratios. Gains persist when also hedging currency risk, diversifying in emerging markets only, and during the crisis period, and increase for long-horizon investors and with short sales. The results have implications for the home equity puzzle.
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Political risk in internationally diversified portfolios
- 1. Political Risk in Internationally Diversified Portfolios Giovanni Pagliardi „ Stavros Zenios ‡ „ BI Norwegian Business School, Oslo ‡University of Cyprus March 8, 2021 Pagliardi, Zenios Political risk in international portfolios March 8, 2021 1 / 12
- 2. Research Framework Pagliardi, Zenios Political risk in international portfolios March 8, 2021 2 / 12
- 3. Research Framework Motivation Pagliardi, Zenios Political risk in international portfolios March 8, 2021 2 / 12
- 4. Research Framework Motivation 1 A global political risk factor (P-factor) is priced in int’l stock markets Pagliardi, Zenios Political risk in international portfolios March 8, 2021 2 / 12
- 5. Research Framework Motivation 1 A global political risk factor (P-factor) is priced in int’l stock markets 2 International diversification exposes to global political risk Pagliardi, Zenios Political risk in international portfolios March 8, 2021 2 / 12
- 6. Research Framework Motivation 1 A global political risk factor (P-factor) is priced in int’l stock markets 2 International diversification exposes to global political risk 3 The impact of political risk on intl porfolios has been neglected Pagliardi, Zenios Political risk in international portfolios March 8, 2021 2 / 12
- 7. Research Framework Motivation 1 A global political risk factor (P-factor) is priced in int’l stock markets 2 International diversification exposes to global political risk 3 The impact of political risk on intl porfolios has been neglected Research questions Pagliardi, Zenios Political risk in international portfolios March 8, 2021 2 / 12
- 8. Research Framework Motivation 1 A global political risk factor (P-factor) is priced in int’l stock markets 2 International diversification exposes to global political risk 3 The impact of political risk on intl porfolios has been neglected Research questions 1 Do international portfolios carry a political risk premium? Pagliardi, Zenios Political risk in international portfolios March 8, 2021 2 / 12
- 9. Research Framework Motivation 1 A global political risk factor (P-factor) is priced in int’l stock markets 2 International diversification exposes to global political risk 3 The impact of political risk on intl porfolios has been neglected Research questions 1 Do international portfolios carry a political risk premium? 2 If yes, how to hedge it? Pagliardi, Zenios Political risk in international portfolios March 8, 2021 2 / 12
- 10. Research Framework Motivation 1 A global political risk factor (P-factor) is priced in int’l stock markets 2 International diversification exposes to global political risk 3 The impact of political risk on intl porfolios has been neglected Research questions 1 Do international portfolios carry a political risk premium? 2 If yes, how to hedge it? 3 Is int’l diversification still beneficial when hedging political risk? Pagliardi, Zenios Political risk in international portfolios March 8, 2021 2 / 12
- 11. This Paper Contribution Pagliardi, Zenios Political risk in international portfolios March 8, 2021 3 / 12
- 12. This Paper Contribution 1 Provide a model to hedge political risk Pagliardi, Zenios Political risk in international portfolios March 8, 2021 3 / 12
- 13. This Paper Contribution 1 Provide a model to hedge political risk 2 Assess benefits of diversification in presence of political risk Pagliardi, Zenios Political risk in international portfolios March 8, 2021 3 / 12
- 14. This Paper Contribution 1 Provide a model to hedge political risk 2 Assess benefits of diversification in presence of political risk Main findings Pagliardi, Zenios Political risk in international portfolios March 8, 2021 3 / 12
- 15. This Paper Contribution 1 Provide a model to hedge political risk 2 Assess benefits of diversification in presence of political risk Main findings 1 International diversification beneficial even when hedging political risk Pagliardi, Zenios Political risk in international portfolios March 8, 2021 3 / 12
- 16. This Paper Contribution 1 Provide a model to hedge political risk 2 Assess benefits of diversification in presence of political risk Main findings 1 International diversification beneficial even when hedging political risk 2 Benefits persist when additionally hedging currency risk Pagliardi, Zenios Political risk in international portfolios March 8, 2021 3 / 12
- 17. This Paper Contribution 1 Provide a model to hedge political risk 2 Assess benefits of diversification in presence of political risk Main findings 1 International diversification beneficial even when hedging political risk 2 Benefits persist when additionally hedging currency risk 3 Hedging especially beneficial for long-term investors Pagliardi, Zenios Political risk in international portfolios March 8, 2021 3 / 12
- 18. Methodology Determine country loadings (β) on the P-factor Pagliardi, Zenios Political risk in international portfolios March 8, 2021 4 / 12
- 19. Methodology Determine country loadings (β) on the P-factor Time-series regression of country excess returns on market and P-factor Pagliardi, Zenios Political risk in international portfolios March 8, 2021 4 / 12
- 20. Methodology Determine country loadings (β) on the P-factor Time-series regression of country excess returns on market and P-factor Build efficient frontiers in the mean-to-CVaR space Pagliardi, Zenios Political risk in international portfolios March 8, 2021 4 / 12
- 21. Methodology Determine country loadings (β) on the P-factor Time-series regression of country excess returns on market and P-factor Build efficient frontiers in the mean-to-CVaR space Unhedged: Minimize CVaR for different levels of expected return Pagliardi, Zenios Political risk in international portfolios March 8, 2021 4 / 12
- 22. Methodology Determine country loadings (β) on the P-factor Time-series regression of country excess returns on market and P-factor Build efficient frontiers in the mean-to-CVaR space Unhedged: Minimize CVaR for different levels of expected return Hedged: Add model constraint: portfolio β equal to zero Pagliardi, Zenios Political risk in international portfolios March 8, 2021 4 / 12
- 23. Methodology Determine country loadings (β) on the P-factor Time-series regression of country excess returns on market and P-factor Build efficient frontiers in the mean-to-CVaR space Unhedged: Minimize CVaR for different levels of expected return Hedged: Add model constraint: portfolio β equal to zero Compute the tangency portfolio Pagliardi, Zenios Political risk in international portfolios March 8, 2021 4 / 12
- 24. Methodology Determine country loadings (β) on the P-factor Time-series regression of country excess returns on market and P-factor Build efficient frontiers in the mean-to-CVaR space Unhedged: Minimize CVaR for different levels of expected return Hedged: Add model constraint: portfolio β equal to zero Compute the tangency portfolio Maximize the mean-to-CVaR ratio Pagliardi, Zenios Political risk in international portfolios March 8, 2021 4 / 12
- 25. P-Factor Loadings and Average Returns Countries more exposed to the P-factor earn higher average returns Pagliardi, Zenios Political risk in international portfolios March 8, 2021 5 / 12
- 26. MTC Efficient Frontiers: Unhedged vs Hedged Unhedged and hedged frontiers very close at the tangency points Difference increases at high risk levels Pagliardi, Zenios Political risk in international portfolios March 8, 2021 6 / 12
- 27. Maximization of Mean-to-CVaR Ratio: Results Hedged ptf outperforms index and naive diversified ptf No statistical difference between unhedged and hedged ptfs Pagliardi, Zenios Political risk in international portfolios March 8, 2021 7 / 12
- 28. CVaR for Different Holding Periods Pagliardi, Zenios Political risk in international portfolios March 8, 2021 8 / 12
- 29. MTC for Different Holding Periods Hedged and unhedged ptfs outperform the index Hedging even more beneficial in the long run Pagliardi, Zenios Political risk in international portfolios March 8, 2021 9 / 12
- 30. Mean-to-CVaR vs Mean-Variance MTC model with short positions diversifies political risk Pagliardi, Zenios Political risk in international portfolios March 8, 2021 10 / 12
- 31. Further Tests Hedging currency and political risk Model-implied returns Short positions in developed markets Partial hedging in emerging markets Alternative political risk factor Subsample: crises period Q3 2007 - Q4 2012 Pagliardi, Zenios Political risk in international portfolios March 8, 2021 11 / 12
- 32. Conclusions Int’l portfolios are significantly exposed to global political risk Pagliardi, Zenios Political risk in international portfolios March 8, 2021 12 / 12
- 33. Conclusions Int’l portfolios are significantly exposed to global political risk We provide a model to hedge it Pagliardi, Zenios Political risk in international portfolios March 8, 2021 12 / 12
- 34. Conclusions Int’l portfolios are significantly exposed to global political risk We provide a model to hedge it Diversification benefits persist when hedging political risk Pagliardi, Zenios Political risk in international portfolios March 8, 2021 12 / 12
- 35. Conclusions Int’l portfolios are significantly exposed to global political risk We provide a model to hedge it Diversification benefits persist when hedging political risk Hedging is especially beneficial for long-term investors Pagliardi, Zenios Political risk in international portfolios March 8, 2021 12 / 12
- 36. Hedging Currency and Political Risk Back to presentation Pagliardi, Zenios Political risk in international portfolios March 8, 2021 1 / 6
- 37. Model-Implied Returns Back to presentation Pagliardi, Zenios Political risk in international portfolios March 8, 2021 2 / 6
- 38. Short Positions in Developed Markets Back to presentation Pagliardi, Zenios Political risk in international portfolios March 8, 2021 3 / 6
- 39. Partial Hedging: Diversification Only in Emerging Markets Back to presentation Pagliardi, Zenios Political risk in international portfolios March 8, 2021 4 / 6
- 40. ICRG Political Risk Factor Back to presentation Pagliardi, Zenios Political risk in international portfolios March 8, 2021 5 / 6
- 41. Subsample: Crises Period Q3 2007 - Q4 2012 Back to presentation Pagliardi, Zenios Political risk in international portfolios March 8, 2021 6 / 6