The Impact of Geopolitical Risk on Stock Returns : Evidence from Inter-Korea Geopolitics

We investigate how corporate stock returns respond to geopolitical risk in the case of South Korea, which has experienced large and unpredictable geopolitical swings that originate from North Korea. To do so, a monthly index of geopolitical risk from North Korea (the GPRNK index) is constructed using automated keyword searches in South Korean media. The GPRNK index, designed to capture both upside and downside risk, corroborates that geopolitical risk sharply increases with the occurrence of nuclear tests, missile launches, or military confrontations, and decreases significantly around the times of summit meetings or multilateral talks. Using firm-level data, we find that heightened geopolitical risk reduces stock returns, and that the effects on stock returns are heterogeneous across different firm characterstics. The reduction is greater especially for large firms and for firms with higher capital intensity. The adverse effect of geopolitical risk is attenuated for the firms with higher foreign ownership and for firms with a higher labor-captital ratio. These results highlight various channels through which geopolitical risk affects stock returns—international portfolio diversification, the real option theroy and the Oi-Hartman-Able effects