Centre for Strategy, Technological Innovation, and Operations Seminar with Prof Stavros Zenios (Durham)

Aggregate confusion in the political risk of markets and portfolios

Abstract

In this talk, I will discuss two lines of research over the last five years to develop theoretically rigorous and empirically relevant models to document the effects of political risk on the financial markets and to 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 4.44% per annum with a Sharpe ratio of 0.70. It is unspanned by the existing asset pricing factors, manifests in all asset classes, and is related to systematic variations in expected global growth and aggregate volatility. This finding is the point of departure to show 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. Political risk hedging is not subsumed by currency hedging, and the diversification gains of politically hedged portfolios persist under currency hedging and transaction cost frictions. Hedging political risk induces equity home bias but does not fully explain the puzzle. Still, our work is not yet done. We currently 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 given the ambiguity in its measurement. We develop hedging models under ambiguity using robust optimization and show that zero-beta portfolios remain politically hedged in- and out-of- sample.

References:

102. D. Gala, G. Pagliardi, and S. A. Zenios (2023) Global political risk and international stock returns. Journal of Empirical Finance, 72:78–102.
103. D. Gala, G. Pagliardi, I. Shaliastovich, and S. A. Zenios (2024) Political risk everywhere. Working paper, available at SSRN, BI Norwegian Business School.
104. 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

About the speaker

Stavros A. Zenios is a Professor of Operations Management and Finance at Durham University, and professor of Finance and Management Science at the University of Cyprus, and a Member of the National Academy of Cyprus. He is a Non-resident Fellow of Bruegel and a Senior Fellow at the Wharton School Financial Institutions Center. He consulted extensively with international institutions and commercial enterprises, including the European Stability Mechanism, the Bank for International Settlements, the Finnish Ministry of Finance, the Cyprus Auditor General, the Union Bank of Switzerland, and the World Bank.

He authored two books and numerous articles in leading international journals in risk management, financial engineering, and management science. His work on personal financial planning received the 2006 EURO Excellence in Practice Award. In 1997, he received the INFORMS prize for his book with Yair Censor Parallel Optimization (Oxford University Press). He also received awards for work on the performance of financial institutions, and two Marie Sklodowska-Curie fellowships. His work on robust optimization is cited extensively, and his book Practical Financial Optimization (Blackwell-Wiley) is used in advanced classes in European and North American Universities. His book with Patrick Harker on the Performance of Financial Institutions (Cambridge University Press) was translated in Chinese.