Political Beta

Using a framework akin to portfolio theory in asset pricing, we introduce the concept of “political beta” to model firm-level export diversification in response to global political risk. The main implication of our model is that a firm is less responsive to changes in political relations with a destination market when that country contributes less (has lower political beta) or even hedges against (has negative political beta) the firm's total political risk. This result follows the diversification logic of portfolio theory, in which an investor values a given asset depending on the asset's contribution to (comovement with) his/her overall investment portfolio. We find patterns consistent with our model using disaggregated Russian firm-by-destination-country data during 1999-2011: trade is positively correlated with political relations, though the effect is far weaker for trading partners whose political relations with Russia are relatively uncorrelated with those of other partners in a firm's export portfolio. Our results highlight the importance of viewing firms' political relations as an undiversifiable source of risk, and more generally points to the value of modeling firms' treatment of risks as a portfolio diversification problem