LO 1: Transmission Channels of Geopolitical Risk to Asset Prices

Geopolitical risks encompass potential adverse events such as wars, terrorist acts, trade restrictions, and interstate tensions that can disrupt international relations and economic stability. These risks have risen notably in recent years: news-based measures of geopolitical risk events, actual military spending relative to GDP, and restrictions on cross-border trade and financial transactions have all increased since 2022. A composite index combining these indicators has reached its highest level in several decades.

Two Key Transmission Channels

1. The Economic Channel

The economic channel operates through actual or expected disruptions to economic activity. Trade and financial restrictions can disrupt supply chains, reverse capital flows, and inflict demand shocks. In military conflicts, damage to infrastructure and civilian populations reduces demand and undermines investment. Stock prices fall when events dampen expected cash flows or raise discount rates. Sovereign risk premiums may increase through fiscal sustainability concerns from higher military spending or declining output. Policy responses to growth and inflation changes can also indirectly affect asset prices.

2. The Market Sentiment Channel

This channel operates through uncertainty and risk aversion, even when no conflict or policy change has materialized. An increase in geopolitical risk can reduce investor confidence and raise risk aversion, with an immediate impact on asset prices as expectations and risk appetite shift.

The Macrofinancial Feedback Loop

KEY CONCEPT: Macrofinancial Feedback Loop Depressed asset valuations caused by geopolitical risks can increase liquidity and credit risks for both financial and nonfinancial institutions. Large and abrupt declines in asset prices can lead to margin and collateral calls, as well as redemption pressures on investment funds. These pressures can trigger asset fire sales and contagion within the broader financial system, creating an adverse macrofinancial feedback loop where financial stress and economic weakness reinforce each other.

Channel	Mechanism	Asset Price Impact
Economic Channel: Trade restrictions	Supply chain disruption, reduced trade volumes, higher input costs	Stock prices fall; commodity prices may rise; currencies of targeted economies depreciate
Economic Channel: Financial restrictions	Capital flow reversals, sanctions, asset freezing, payment disruptions	Capital outflows; sovereign risk premiums rise; exchange rate depreciation
Economic Channel: Physical/civilian damage	Infrastructure destruction, reduced productive capacity, civilian displacement	Severe stock price declines in affected country; long-term growth impairment
Market Sentiment Channel	Heightened uncertainty, lower investor confidence, increased risk aversion	Broad-based sell-offs; flight to safety (safe haven sovereign yields decline); VIX spikes

Policy Recommendations

The chapter recommends several policy measures to address potential financial stability consequences of geopolitical risks:

Scenario analysis and stress testing: Financial institutions and their oversight bodies should devote adequate resources to identifying, quantifying, and managing geopolitical risks. Stress testing should incorporate the interaction of geopolitical risks with traditional market, credit, and liquidity risks.

Capital and liquidity buffers: Financial institutions should hold adequate buffers to absorb extreme but plausible losses from geopolitical risk materialization.

Deepen financial markets in EMDEs: Deeper financial markets and more developed derivatives markets in emerging market and developing economies support investors’ ability to manage and hedge financial risks posed by geopolitical shocks. Robust regulatory frameworks should accompany this development.

Maintain fiscal and reserve buffers: Adequate fiscal policy space and international reserve buffers help mitigate adverse effects of geopolitical risk events. Economies reliant on external financing should ensure adequate reserve levels to cushion adverse shocks and manage capital flow volatility.

Crisis preparedness: Crisis management frameworks should be strengthened to deal with potential financial instability from escalating geopolitical tensions, including appropriate tools for stress in nonbank financial intermediaries.

EXAM TIP The two-channel framework (economic vs. market sentiment) is a natural testing point. Be prepared to identify which channel is operating in a given scenario. The economic channel involves actual disruptions (trade, finance, physical), while the sentiment channel involves uncertainty and risk aversion even without realized events. The macrofinancial feedback loop concept, where asset price declines cause margin calls and fire sales which cause further declines, is a key testable mechanism.

Practice Question 1 Following an unexpected military confrontation between two neighboring nations, global stock markets decline sharply, the VIX index spikes to its highest level in two years, and option-implied volatility rises across all major indices. No trade sanctions have been announced, and supply chains remain intact. Which transmission channel best explains the immediate market reaction? A. The economic channel, because supply chain disruptions are reducing firms’ expected cash flows. B. The market sentiment channel, because heightened uncertainty and risk aversion are depressing asset prices even before any tangible economic impact. C. The macrofinancial feedback loop, because margin calls are forcing fire sales of financial assets.

Correct Answer: B The scenario specifies that no trade restrictions or supply disruptions have occurred. The immediate reaction, characterized by a VIX spike and broad sell-offs, reflects increased uncertainty and reduced investor confidence, which is the market sentiment channel. Choice A is incorrect because no supply chain disruption has materialized. Choice C describes a secondary amplification mechanism, not the primary transmission channel in this scenario.

Practice Question 2 A policymaker is designing recommendations to help emerging market financial institutions prepare for geopolitical risk events. Which of the following measures is least likely to be recommended based on the IMF’s framework? A. Conducting scenario analysis that integrates geopolitical risks with traditional market and credit risks. B. Reducing capital buffers during periods of low geopolitical risk to boost lending and economic growth. C. Maintaining adequate international reserves to cushion against adverse capital flow volatility.

Correct Answer: B The IMF framework recommends maintaining adequate capital and liquidity buffers at all times to absorb extreme but plausible losses from geopolitical risks. Reducing buffers during calm periods would leave institutions vulnerable when risks materialize. Choices A and C are both explicitly recommended in the policy framework.

LO 2: Differential Impact Across Countries, Sectors, and Asset Classes

The impact of geopolitical risk events on asset prices varies significantly across countries, sectors, and asset classes. The nature of a country’s economy, its exposure to global commodity markets, and its sectoral composition all shape how financial markets respond to geopolitical shocks.

Country-Level Variation: Commodity Importers vs. Exporters

Commodity importers tend to suffer more: their stock markets decline more sharply, sovereign CDS spreads widen, and currencies depreciate against the US dollar. Geopolitical events often disrupt commodity supplies, raising input costs for importers while weakening their terms of trade.

Commodity exporters often experience positive stock returns, particularly when events involve oil-producing regions. Rising commodity prices benefit revenue streams and fiscal positions. Their sovereign CDS spreads may even tighten.

Sector-Level Variation

Sector	Typical Response	Rationale
Energy	Positive returns	Supply disruption fears push up oil and commodity prices, boosting revenues
Defense / Aerospace	Positive returns	Expectations of increased government military expenditure and defense contracts
Consumer Goods / Retail	Negative returns	Weaker consumer demand, higher input costs, supply chain disruptions
Financials / Banks	Negative returns	Increased credit risk, potential loan losses, higher uncertainty depresses valuations
Utilities	Modest negative	Higher energy costs for operations; partially offset by regulated revenue streams

Asset Class Responses

Beyond equities, other asset classes respond to geopolitical shocks in distinctive ways:

Sovereign CDS spreads generally increase more for emerging market economies and commodity non-exporters. For advanced economies, median sovereign CDS spreads and government bond yields typically decline after major global events, suggesting flight-to-safety behavior.

Long-term sovereign yields tend to decline in traditional safe haven countries (Germany, Japan, Switzerland, the United Kingdom, and the United States) as investors seek safer assets. In contrast, yields rise in emerging markets.

Exchange rates: Currencies, especially of commodity-importing countries, tend to weaken after major global geopolitical risk events, reflecting capital outflows and weaker growth expectations.

Commodity prices: Oil prices generally rise after major geopolitical events on fears of supply disruption. Gold prices also increase as investors seek safe haven assets. Broader precious metals follow a similar pattern.

The takeaway: The impact of geopolitical risk is not uniform. Commodity exporters may benefit while importers suffer; defense and energy sectors gain while consumer sectors lose; and safe haven sovereign bonds attract flows while emerging market debt faces outflows. For risk management, understanding these differential effects is critical.

EXAM TIP The commodity importer vs. exporter distinction is a high-probability test point. Know that importers face wider CDS spreads, weaker currencies, and lower stock returns, while exporters may see the opposite. Also note the sector-level pattern: energy and defense benefit, while consumer goods and financials typically suffer.

Practice Question 3

Country X is a major oil-importing emerging market economy. Following a sudden military conflict in an oil-producing region, which combination of asset price movements is Country X most likely to experience?

• A. Higher stock prices, narrower sovereign CDS spreads, and a stronger domestic currency.
• B. Lower stock prices, wider sovereign CDS spreads, and a weaker domestic currency.
• C. Higher stock prices, wider sovereign CDS spreads, and a weaker domestic currency.

Correct Answer: B As a commodity importer, Country X faces higher energy input costs from the supply disruption, which hurts corporate profitability (lower stocks), worsens fiscal position (wider CDS), and weakens the terms of trade (currency depreciation). Choice A describes the pattern more typical of a commodity exporter. Choice C is inconsistent because higher input costs would depress, not boost, aggregate stock prices for an oil importer.

Practice Question 4 After a major global geopolitical risk event, an analyst observes that 10-year government bond yields in Germany and Japan decline, while yields in several emerging market economies increase. Which explanation best accounts for this divergence? A. Germany and Japan have weaker fiscal positions, so investors expect central bank easing. B. Emerging market economies are commodity exporters benefiting from higher commodity prices. C. Investors engage in flight-to-safety behavior, seeking traditional safe haven sovereign bonds, while higher uncertainty raises risk premiums in emerging markets.

Correct Answer: C Germany and Japan are traditional safe haven countries. After geopolitical shocks, investors shift capital toward these perceived safe assets, pushing yields down. In contrast, higher uncertainty and risk aversion raise sovereign risk premiums in emerging markets. Choice A is incorrect; Germany and Japan have strong fiscal positions. Choice B does not explain the yield increase in EMs, and not all EMs are commodity exporters.

LO 3: Stock Market Responses to Geopolitical Risk Events

Aggregate Stock Price Reactions

The IMF uses a panel vector autoregression (VAR) model to isolate the causal effect of geopolitical risk shocks on stock prices, controlling for macroeconomic factors and policy responses. Key findings:

Average shocks cause a modest decline in aggregate stock prices of about 0.3% in response to a country-specific geopolitical risk shock, with the effect persisting for at least two years.

Major shocks (defined as those increasing the geopolitical risk index by at least two standard deviations above the mean) have an impact roughly 7 times larger and are notably persistent.

Global shocks have an impact of about 1% on average and persist for about a quarter. Given that the average three-month stock market return across countries in the sample is about 0.1%, a typical shock is 3 times larger, and a large shock is roughly 20 times larger, than the average return.

Following major shocks, the VIX tends to spike, reflecting both increased risk aversion and greater macroeconomic uncertainty. A decomposition shows that while both components rise, the uncertainty component is more notable and persistent, particularly for global shocks.

Case Study: Russia’s 2022 Invasion of Ukraine

Russia’s invasion of Ukraine on February 24, 2022, had a severe and immediate impact on stock markets. The Russian stock market fell by 33% on the day of invasion, and trading on the Ukrainian stock exchange was suspended.

Cross-border spillovers were significant and operated through multiple channels:

Sector effects in third countries: Defense sector stocks in other economies generally rose on expectations of increased military spending. Energy sector stocks also benefited as oil prices surged. By contrast, consumer discretionary and financial stocks in most countries declined.

Revenue exposure channel: Firms generating significant revenues from Russia or Ukraine experienced an additional decline in stock prices of about 0.7 percentage points within seven days, after controlling for country and sector effects.

Subsidiary presence channel: Firms with a subsidiary in Russia or Ukraine saw their stock returns decline by approximately 2.5 percentage points on average within a week of the invasion.

Post-invasion adjustment: Over time, firms reduced their exposure to Russia. The share of firms with Russian subsidiaries dropped from over 2% (2015-21) to about 1.5% (2023). However, while many European firms reduced their revenue exposure to Russia, firms in some other countries increased theirs, suggesting a reorientation of trade linkages.

Case Study: China-US Trade Tensions (2018-2024)

Trade tensions between the US and China, which accelerated in 2018, are reflected in elevated geopolitical risk indices for China around that period. The IMF examines stock price reactions to major tariff announcements.

Impact of US tariff announcements on Chinese firms: Stock prices of Chinese firms declined by nearly 4% on average after US tariff announcements, affecting firms in both directly targeted sectors and other sectors. Some individual announcements had even larger effects; for example, the May 6, 2019, announcement of tariffs on $200 billion of Chinese products caused an average decline of nearly 8%.

Spillback effects on US firms: US firms’ stock prices declined by 1.3% on average after their own government’s tariff announcements on China, reflecting anticipated retaliation, supply chain interconnectedness, and broader uncertainty.

Retaliatory tariff effects: China’s retaliatory tariff announcement on August 23, 2019, caused US firm stock prices to fall by 1.6-1.8% and Chinese firm stock prices to decline by 0.3-0.7%.

Revenue and subsidiary channels: Chinese firms with higher revenue exposure to the US experienced about 0.2 percentage points of additional decline. Firms with cross-border subsidiaries (Chinese firms in the US or US firms in China) suffered approximately 0.6 percentage points more than comparable firms without such presence.

KEY CONCEPT: Cross-Border Contagion Channels Geopolitical risk events spill across borders through three firm-level channels: (1) Trade linkages, where involvement of a trading partner in a conflict reduces stock returns by about 1 percentage point; (2) Revenue exposure, where firms earning significant revenue from affected countries suffer additional declines; and (3) Subsidiary/shareholder presence, where physical corporate presence in affected countries amplifies the stock price impact. Military conflicts transmit more strongly than other event types, and emerging market firms are generally more vulnerable than advanced economy firms.

EXAM TIP Know the magnitude benchmarks: average country-specific shock causes ~0.3% decline; major shocks are ~7x larger; global shocks cause ~1% decline. For the Russia-Ukraine case, remember the subsidiary channel (2.5 pp) was larger than the revenue exposure channel (0.7 pp). For China-US tariffs, note that US firms also suffered from their own government’s tariff announcements (spillback effect of 1.3%), and that retaliatory tariffs from China affected both US and Chinese firms.

Practice Question 5

A European manufacturing company has a subsidiary in Russia and derives 8% of its revenues from Russian clients. Following Russia’s 2022 invasion of Ukraine, the company’s stock price is most likely to be adversely affected through which channel to the greatest degree?

• A. Revenue exposure, because 8% revenue dependence on Russia is the dominant risk factor.
• B. Subsidiary presence, because physical corporate presence in the conflict-affected country amplified stock price declines more than revenue exposure.
• C. Market sentiment, because the stock price reaction would be entirely driven by broad risk aversion unrelated to firm-specific exposures.

Correct Answer: B The IMF’s analysis found that firms with subsidiaries in Russia or Ukraine experienced approximately 2.5 percentage points of additional stock price decline within one week, compared with about 0.7 percentage points for firms with high revenue exposure. The subsidiary channel had a larger impact. Choice A understates the subsidiary effect. Choice C ignores the firm-specific cross-border linkages documented in the research.

Practice Question 6

Following a US announcement of significant new tariffs on Chinese goods, stock prices of US firms in sectors not directly targeted by the tariffs also declined by approximately 1.3%. Which of the following best explains this observation?

• A. The tariffs caused an immediate increase in input costs for all US firms equally.
• B. The broad decline likely reflects anticipated retaliatory tariffs, supply chain interconnectedness across sectors, and a general rise in uncertainty and investor risk aversion.
• C. US firms in non-targeted sectors had significant revenue exposure to China that made them directly vulnerable to the tariffs.
  made them directly vulnerable to the tariffs.

Correct Answer: B The IMF notes that the strong impact on firms in sectors not directly affected by tariffs could indicate interconnectedness among firms, as well as broader uncertainty and investor risk aversion. The decline reflects anticipation of retaliation, economic linkages across sectors, and a general rise in uncertainty. Choice A is incorrect because non-targeted firms would not face immediate input cost increases from the specific tariffs. Choice C is too narrow; the broad-based decline across all sectors suggests systemic uncertainty rather than purely firm-specific revenue exposure.

LO 4: Effects of Geopolitical Shocks on Sovereign Risk Premiums

Geopolitical risks affect sovereign risk premiums through several mechanisms: higher military spending strains fiscal positions, economic activity deterioration raises debt-to-GDP ratios, and increased uncertainty raises the compensation investors demand for holding sovereign debt.

Sovereign CDS Spread Responses

The IMF estimates a panel regression model using sovereign CDS spreads as a proxy for sovereign risk premiums. Key findings:

Domestic military conflicts cause the largest CDS spread widening. Within one month of a country’s involvement in a major international military conflict, sovereign CDS spreads widen by approximately 40 basis points in advanced economies and by approximately 180 basis points in emerging market economies.

Foreign geopolitical events also affect sovereign risk premiums through trading partner linkages. When a country’s main export or import partner becomes involved in an international military conflict, the country’s own sovereign CDS spreads widen, reflecting the negative impact on economic activity and upward pressures on inflation.

Amplifying Factors in Emerging Markets

Three factors determine how severely a geopolitical shock amplifies sovereign risk premiums in emerging markets:

Factor	Effect on CDS Spreads	Mechanism
High public debt-to-GDP ratio	Larger widening of sovereign CDS spreads	Limited fiscal space to absorb additional military or economic support spending
Low international reserve adequacy	~100 basis points additional widening	Reduced ability to defend the currency or provide emergency liquidity
Weak institutional quality	~120 basis points additional widening	Lower investor confidence in effective policy response and governance

Safe Haven Effects

Traditional safe haven countries (Germany, Japan, Switzerland, the United Kingdom, and the United States) exhibit a distinctive pattern. Following major domestic geopolitical risk events, long-term sovereign yields in advanced economies tend to decline, driven primarily by these safe haven nations. Safe haven effects are even more pronounced for major foreign geopolitical risk events, when long-term yields in non-safe-haven advanced economies rise but remain stable or decline in safe haven countries.

The Sovereign-Financial Feedback Loop

Rising geopolitical risks create a feedback loop with fiscal risk. A significant geopolitical event increases sovereign risk premiums, amplifying fiscal vulnerabilities. These fiscal vulnerabilities, in turn, further exacerbate the impact on sovereign risk premiums. Higher sovereign spreads adversely affect bank balance sheets and lending, especially in countries with less well-capitalized banking systems and higher fiscal vulnerabilities.

The takeaway: Sovereign risk premiums respond most to military conflicts, and the response is far larger in emerging markets than in advanced economies. The amplification is greatest where fiscal space is limited, reserves are low, and institutional quality is weak. Safe haven countries experience the opposite: their yields decline as investors seek safety.

EXAM TIP Remember the key magnitudes: ~40 bps widening in AEs vs. ~180 bps in EMs after military conflicts. The three amplifying factors (high debt, low reserves, weak institutions) are distinct from each other and produce additive effects. Also note the asymmetry: safe haven countries see yields decline (flight to safety), while other AEs and EMs see yields rise.

Practice Question 7

Two emerging market economies, Country A and Country B, both experience a major geopolitical shock when their primary trading partner is involved in a military conflict. Country A has a public debt-to-GDP ratio above the median for emerging markets and international reserves below the IMF’s adequacy threshold. Country B has moderate debt levels and adequate reserves but scores below the median on institutional quality indicators. Which country is most likely to experience a larger widening of sovereign CDS spreads?

• A. Country A, because it has both high debt and low reserves, which produce compounding amplification effects.
• B. Country B, because weak institutional quality alone produces a larger amplification effect (~120 bps) than either high debt or low reserves individually.
• C. Both countries would experience approximately equal CDS spread widening, because each has exactly one amplifying factor.

Correct Answer: A Country A has two amplifying factors (high debt and low reserves), whereas Country B has one (weak institutions). Although the low reserves factor alone adds approximately 100 bps and weak institutions adds approximately 120 bps, Country A faces compounding vulnerabilities from both limited fiscal space and reduced ability to defend its currency. The combination of two vulnerabilities makes Country A more exposed. Choice B is incorrect because it counts only one factor for each country and ignores that Country A has two. Choice C incorrectly states that Country A has only one factor.

LO 5: Pricing of Geopolitical Risk in Equity and Options Markets

Geopolitical Risk Beta (GPR Beta)

The GPR beta measures the sensitivity of a stock’s returns to geopolitical risk shocks, after controlling for standard market factors. The IMF computes GPR betas for a large cross-section of firms and finds:

Heterogeneous responses across sectors: Energy and defense sector stocks tend to have higher (positive) GPR betas, meaning their value rises after geopolitical risk shocks. Consumer goods stocks tend to have lower (negative) GPR betas, meaning their value falls. This is consistent with the observation that geopolitical events raise energy prices but reduce consumer demand.

Symmetric distribution: The distribution of GPR betas is nearly symmetric, with a large number of stocks exhibiting both positive and negative betas. This means some stocks serve as natural hedges against geopolitical risk while others amplify exposure.

Risk Premium Findings: A Structural Shift in 2022

The IMF uses the Fama-MacBeth regression framework and decile portfolio analysis to estimate whether investors price geopolitical risk. The results reveal a notable structural shift:

Period	GPR Beta Premium	Interpretation
2012-2021 (Pre-invasion)	Negative premium (~-0.5% per month for decile portfolio)	Investors demanded a premium for holding stocks that declined during geopolitical events; hedging stocks offered lower returns
2022-2024 (Post-invasion)	Positive premium (~+1.1% per month for decile portfolio)	Investors shifted to favoring stocks that hedged against geopolitical risk, willing to pay a premium for protection

This shift implies that before Russia’s invasion of Ukraine, investors treated geopolitical risk as a relatively remote concern and demanded compensation for bearing it. After the invasion demonstrated the severity of realized geopolitical risk, investors began favoring geopolitical hedges, driving up the prices (and reducing the expected returns) of stocks that performed well during geopolitical shocks.

Options Market Pricing

Options markets provide additional evidence on geopolitical risk pricing through the cost of downside protection:

Russia’s Invasion of Ukraine

Premiums for protecting against downside risk (declining stock prices) and against downside tail risk (extreme drops) increased moderately before Russia’s invasion but surged notably around the event. The increase was largest for options on Russian firms, but premiums also rose for options on European firms, reflecting their higher exposure. The energy sector’s option premiums remained stable, consistent with energy firms benefiting from rising prices. Firms with greater revenue exposure or subsidiary presence in Russia and Ukraine faced higher option premiums.

China-US Trade Tensions

For both Chinese and US firms, option premiums for downside and tail risk protection increased after the 2018-19 tariff announcements. Premiums did not increase for firms in countries not directly involved. Tail risk premiums rose more prominently than general downside risk premiums, indicating that trade tensions had a stronger impact on perceived extreme outcomes than on average expected losses.

The takeaway: Investors do price geopolitical risk, but the nature of pricing shifted after 2022. Pre-invasion, investors demanded a premium for bearing geopolitical risk. Post-invasion, they shifted to valuing hedging properties, paying more for stocks that protect against geopolitical shocks. In options markets, both downside and tail risk premiums rise around geopolitical events, with tail risk premiums showing the larger response.

EXAM TIP The structural shift in 2022 is a critical testing point. Before Russia’s invasion: negative GPR beta premium (compensation for bearing risk). After the invasion: positive GPR beta premium (investors favoring hedges). In options markets, remember that tail risk premiums react more strongly than general downside risk premiums, especially during trade tension events.

Practice Question 8 An analyst constructs a portfolio that buys stocks with the highest GPR betas (top decile) and sells stocks with the lowest GPR betas (bottom decile). Based on the IMF’s findings, which statement about this portfolio’s risk-adjusted returns is most accurate? A. The portfolio generated positive alpha during 2012-2021 and negative alpha after 2022. B. The portfolio generated negative alpha of approximately 0.5% per month during 2012-2021 and positive alpha of approximately 1.1% per month after 2022. C. The portfolio generated consistently positive alpha across the entire sample period because geopolitical risk is always positively priced.

Correct Answer: B The IMF’s decile portfolio analysis found statistically significant negative premiums of about 0.5% per month during 2012-2021 (meaning investors demanded compensation for bearing geopolitical risk, so hedging stocks underperformed) and positive premiums of about 1.1% after 2022 (meaning investors paid a premium for hedging stocks after Russia’s invasion). Choice A reverses the signs. Choice C ignores the structural shift documented in the research.

Practice Question 9 Following the 2018-2019 US tariff announcements on Chinese goods, an analyst examines option premiums on Chinese and US firm stocks. Which observation is most consistent with the IMF’s findings? A. Downside risk premiums increased more than tail risk premiums for both Chinese and US firms. B. Tail risk premiums increased more prominently than general downside risk premiums, and the increases were concentrated in Chinese and US firms rather than firms in other countries. C. Option premiums declined for Chinese firms because investors expected tariffs to be reversed quickly.

Correct Answer: B The IMF found that tail risk premiums rose more prominently than general downside risk premiums during the trade tension period, and the premium increases were specific to Chinese and US firms. Firms in other countries did not experience significant premium increases, on average. Choice A reverses the relative magnitudes. Choice C contradicts the empirical findings.

LO 6: Implications for Banks and Nonbank Financial Institutions

Financial Sector Exposures to Geopolitical Risk

Banks and nonbank financial institutions hold significant assets in countries exposed to major geopolitical risk events. Cross-border bank claims and liabilities involving countries affected by major events represent approximately 8% and 10% of total cross-border claims and liabilities, respectively, as of the second half of 2024. The share of equity fund holdings in assets domiciled in these countries reached 13% in 2024.

Portfolio Rebalancing After Russia’s Invasion of Ukraine

Financial institutions reduced their exposure to Russia and Ukraine after the 2022 invasion:

Banks: Cross-border banking claims on Russia and Ukraine fell significantly after both the 2014 annexation of Crimea and the 2022 invasion.

Investment funds: Direct exposures to both countries declined by approximately 60% after Russia’s invasion. Funds also reduced indirect exposures by decreasing their holdings of firms in third countries that had high revenue or subsidiary exposure to Russia or Ukraine.

Impact on Bank Stability and Lending

The IMF uses an unbalanced panel of more than 6,000 banks from 21 advanced economies and 15 emerging markets to estimate the impact of geopolitical risk events on bank equity and lending. Key findings:

Bank equity tends to decline when a bank’s home country or key foreign counterparts are involved in an international military conflict. The decline is larger for banks in emerging market economies, reflecting their greater vulnerability.

Loan growth declines following geopolitical risk events, with the reduction more pronounced in emerging markets. This occurs both when the domestic economy is involved in a conflict and when key foreign counterparts are affected. The research also confirms increases in borrowing costs and nonperforming loans after major events.

Metric	Advanced Economies	Emerging Markets
CDS spread widening (domestic military conflict)	~40 basis points	~180 basis points
Bank equity impact	Modest decline	Larger decline
Loan growth impact	Moderate reduction	More pronounced reduction
Borrowing costs	Some increase	Larger increase
Nonperforming loans	Modest rise	More significant rise

Impact on Investment Funds

Investment funds with significant exposure to countries involved in geopolitical risk events experience lower returns and lower net flows. The effects vary by fund type and event severity:

Bond funds are more affected than equity funds. Across international military conflicts, bond funds with 10% exposure to affected countries suffered a 1.0 percentage point decrease in returns and a 2.3 percentage point decline in flows. Equity funds experienced smaller impacts: about 0.2 percentage points in returns and 0.3 percentage points in flows.

Russia-Ukraine case study: Investment funds with 10% of holdings directly exposed to Russian or Ukrainian assets experienced approximately a 6% decline in cumulative returns within one week and an 8% decrease in cumulative flows over six months following the invasion.

China-US tariffs: Investment funds holding Chinese firms in sectors affected by US tariffs experienced somewhat lower returns (about 0.1% decline in the month following announcements), but there was no statistically significant impact on fund flows.

Tail Risks to Stock Market Returns

An increase in global geopolitical risk raises downside tail risks to aggregate stock market returns (defined as the 10th percentile of the return distribution). A two-standard-deviation increase in the global geopolitical risk index is associated with approximately a 2-percentage point decline in downside tail risk for stock returns in advanced economies at a six-month horizon. For emerging markets, country-specific events have a larger impact, raising downside tail risk by about 3 percentage points. These effects operate through the economic channel by affecting economic activity and expected cash flows, and they persist beyond the impact of general economic uncertainty.

The takeaway: Geopolitical risk events affect financial institutions through multiple channels: direct asset losses, reduced lending, higher borrowing costs, and fund outflows. The impact is systematically larger for emerging market banks and for bond funds relative to equity funds. Financial institutions have shown some ability to rebalance portfolios aftershocks, but the process takes time and the initial impact can be severe.

EXAM TIP Key distinctions to remember: (1) Bond funds are hit harder than equity funds (1.0 pp vs. 0.2 pp return decline; 2.3 pp vs. 0.3 pp flow decline). (2) Emerging market banks suffer more than advanced economy banks on all metrics. (3) The Russia-Ukraine case showed severe impact: 6% return decline in one week, 8% flow decline over six months for funds with 10% direct exposure. (4) The China-US tariff impact on funds was modest and flows were not significantly affected.

Practice Question 10 An investment fund manager oversees two funds: Fund A is a bond fund with 12% of its holdings in assets domiciled in a country that has just become involved in a major military conflict. Fund B is an equity fund with the same 12% exposure to the same country. Based on the IMF’s findings, which fund is most likely to experience a larger negative impact on both returns and net flows? A. Fund B, because equity markets react more strongly to geopolitical risk than bond markets. B. Fund A, because bond funds with exposure to conflict-affected countries experience larger return declines and substantially larger flow declines than comparable equity funds. C. Both funds would experience approximately equal impacts, because the exposure percentage is the same.

Correct Answer: B The IMF’s research demonstrates that bond funds are more severely affected than equity funds across international military conflicts. Bond funds with 10% exposure experienced a 1.0 pp return decline and 2.3 pp flow decline, compared with 0.2 pp returns and 0.3 pp flows for equity funds. The flow impact for bond funds is roughly 8 times larger than for equity funds. Choice A reverses the finding. Choice C ignores the systematic difference between bond and equity fund sensitivity.

Practice Question 11 Following a major geopolitical shock, a bank supervisor observes that banks in Country X (an emerging market) show declining equity ratios and contracting loan growth, while banks in Country Y (an advanced economy) show stable equity ratios and only modest lending reductions. Which explanation is most consistent with the IMF’s findings? A. Banks in Country Y have lower exposure to geopolitical risk events because they do not engage in cross-border lending. B. Emerging market banks are systematically more vulnerable to geopolitical risk events due to weaker capitalization, greater dependence on cross-border funding, and higher exposure to macroeconomic volatility. C. Advanced economy banks are immune to geopolitical risk events because they benefit from central bank support.

Correct Answer: B The IMF’s research consistently finds that geopolitical risk impacts are stronger for emerging market banks, reflecting their greater vulnerability and weaker capacity to absorb shocks. This includes larger equity declines, more pronounced loan growth reductions, and greater increases in nonperforming loans. Choice A is incorrect because advanced economy banks also engage in cross-border lending. Choice C is too absolute; advanced economy banks are affected, just less severely.