Geopolitical Risk and U.S. Market Cap Indices
Töyrä, Ossian (2024-05-23)
Julkaisun pysyvä osoite on
https://urn.fi/URN:NBN:fi-fe2024052335779
https://urn.fi/URN:NBN:fi-fe2024052335779
Tiivistelmä
Geopolitical risk has gained popularity in financial research in recent years. Prior research has shown geopolitical risk to potentially have explanatory power over stock returns. However, the form and the extent of this relationship remain disputed among scholars. One unexplored aspect of this relationship is whether geopolitical risk influences stock returns asymmetrically based on the market capitalisation of the company. This thesis aims to contribute to this discussion by examining geopolitical risk as an explanatory variable of stock returns between different company size classes, while also providing additional evidence on the shape of the relationship between geopolitical risk and individual stock indices.
In its main tests, this thesis examined daily data, covering the period from the beginning of the year 1999 until the end of October 2023. To approximate geopolitical risk, the paper utilised the newspaper-based GPR indices and tested their explanatory power over the daily returns of large-, mid-, small-, and micro-cap stock indices, composed of U.S.-based companies. The methodology of the paper is divided into two segments. In the first segment, the explanatory power of the GPR indices on individual stock indices was tested through a quantile autoregression model. In the second phase of testing, several size-based portfolios were constructed to mimic the return differences of varying company size classes. The significance of geopolitical risk on these portfolios' returns was tested using a GARCH(1,1) model while being controlled for crude oil prices.
The results obtained from the empirical testing of individual stock indices did show that geopolitical risk has influence over stock returns and the relationship is negative, regardless of company size. For the size-based portfolios, the results indicated that geopolitical risk has explanatory power over the return differences between micro-cap companies and larger companies. The same relationship among large-, mid-, and small-cap companies was deemed statistically insignificant. Further testing also revealed that the explanatory power of geopolitical risk over the size-based return differences is time-variant.
The main conclusions drawn from these results are twofold. Firstly, the findings of this thesis support the notion that geopolitical risk has a negative relationship with daily stock returns. Secondly, geopolitical risk does have an asymmetric relationship to the stock returns of companies with different market capitalisations. However, this relationship is not stable across time and could only be found in the return difference of micro-caps versus their larger counterparts. Furthermore, contrary to earlier literature, this thesis does find that geopolitical acts have more explanatory power over stock returns than geopolitical threats.
In its main tests, this thesis examined daily data, covering the period from the beginning of the year 1999 until the end of October 2023. To approximate geopolitical risk, the paper utilised the newspaper-based GPR indices and tested their explanatory power over the daily returns of large-, mid-, small-, and micro-cap stock indices, composed of U.S.-based companies. The methodology of the paper is divided into two segments. In the first segment, the explanatory power of the GPR indices on individual stock indices was tested through a quantile autoregression model. In the second phase of testing, several size-based portfolios were constructed to mimic the return differences of varying company size classes. The significance of geopolitical risk on these portfolios' returns was tested using a GARCH(1,1) model while being controlled for crude oil prices.
The results obtained from the empirical testing of individual stock indices did show that geopolitical risk has influence over stock returns and the relationship is negative, regardless of company size. For the size-based portfolios, the results indicated that geopolitical risk has explanatory power over the return differences between micro-cap companies and larger companies. The same relationship among large-, mid-, and small-cap companies was deemed statistically insignificant. Further testing also revealed that the explanatory power of geopolitical risk over the size-based return differences is time-variant.
The main conclusions drawn from these results are twofold. Firstly, the findings of this thesis support the notion that geopolitical risk has a negative relationship with daily stock returns. Secondly, geopolitical risk does have an asymmetric relationship to the stock returns of companies with different market capitalisations. However, this relationship is not stable across time and could only be found in the return difference of micro-caps versus their larger counterparts. Furthermore, contrary to earlier literature, this thesis does find that geopolitical acts have more explanatory power over stock returns than geopolitical threats.