Geopolitical Risk

In October 1973, Arab members of OPEC announced an oil embargo against nations supporting Israel in the Yom Kippur War. Within months, crude prices quadrupled from $3 to $12 per barrel. Stock markets crashed—the Dow Jones Industrial Average fell 45% from January 1973 to December 1974. The postwar economic order, built on the assumption of cheap and abundant energy, entered a decade of stagflation. Investors who had dismissed Middle Eastern politics as irrelevant to portfolio management learned otherwise.

Geopolitical risk—the possibility that political events, conflicts, and policy shifts will produce economic consequences—has always existed. What has changed is the recognition that such risks can be analyzed systematically, measured (however imperfectly), and incorporated into investment and policy decisions. For investors allocating capital across borders and policymakers navigating an increasingly contested international environment, understanding geopolitical risk has become essential.

The costs of geopolitical shocks are substantial. Russia’s 2022 invasion of ukraine triggered an estimated $1.6 trillion in global economic losses during its first year alone, according to IMF calculations. European natural gas prices spiked 400% from pre-invasion levels. Global food prices rose 23% in 2022, contributing to food insecurity affecting over 345 million people. Insurance industry losses from the conflict exceeded $15 billion. These cascading effects demonstrate how geopolitical events in one region reverberate through the interconnected global economy.

Defining Geopolitical Risk¶

Geopolitical risk encompasses the economic and financial consequences of political phenomena: wars, territorial disputes, regime changes, sanctions, trade conflicts, terrorism, and the policies governments adopt in response to perceived threats. The concept bridges geopolitics—the study of how geography and power shape international relations—and geoeconomics—the use of economic tools for strategic ends.

Several characteristics distinguish geopolitical risk from ordinary political risk:

Cross-border transmission means that events in one country affect economic conditions elsewhere. A war in Ukraine raises food prices in Egypt (which imports 80% of its wheat, half from Russia and Ukraine pre-war); a trade dispute between the United States and China disrupts supply chains in Vietnam; sanctions on Russia reshape energy markets in Europe. Geopolitical risk travels through trade, investment, commodity, and financial linkages. The IMF estimates that a serious fragmentation of the global economy along geopolitical lines could reduce global GDP by 2.5-7% permanently.

State-level agency places governments at the center of risk generation. While political risk includes regulatory changes, contract disputes, and domestic instability, geopolitical risk focuses on actions states take in competition or conflict with one another. The relevant actors are foreign ministries, defense establishments, and heads of government rather than regulatory agencies or local officials. Global military spending reached $2.24 trillion in 2022—the highest level ever recorded—reflecting states’ preparations for geopolitical competition.

Strategic interaction means that geopolitical outcomes depend on the choices of multiple actors responding to one another. A trade restriction invites retaliation; a military buildup triggers a security dilemma; an alliance commitment shapes adversary calculations. Understanding geopolitical risk requires anticipating not just individual state behavior but the dynamics of action and reaction. The US-China trade war that began in 2018 illustrates this dynamic: American tariffs on $360 billion of Chinese goods prompted Chinese retaliation on $110 billion of American exports, with each round escalating until a partial truce.

Discontinuity and tail risk characterize the distribution of geopolitical shocks. Most days, nothing dramatic happens; markets discount incremental developments. But wars, revolutions, and financial crises—though rare—produce outsized effects when they occur. Geopolitical risk is fat-tailed: the expected value of low-probability, high-impact events dominates the risk calculus. The COVID-19 pandemic—partly a geopolitical event given debates over origins, vaccine diplomacy, and supply chain reshoring—caused an estimated $12.5 trillion in cumulative global output losses through 2024.

Types of Geopolitical Risk¶

Analysts typically distinguish several categories, each with distinct characteristics and transmission mechanisms:

Interstate conflict remains the most severe form. War destroys capital, disrupts trade, displaces populations, and consumes government resources. The ukraine conflict has caused an estimated $411 billion in direct damage to Ukrainian infrastructure through 2024, while Russia’s war costs are estimated at $211 billion for 2022-2023 alone. Even short of actual combat, military tensions raise risk premiums, deter investment, and divert resources to defense. Taiwan Semiconductor (TSMC) shares fell 8% following Nancy Pelosi’s August 2022 Taiwan visit as investors priced conflict risk. The prospect of war between great powers—the United States and China over Taiwan, for instance—represents the most consequential tail risk in contemporary geopolitics, with some estimates suggesting a Taiwan conflict could cost the global economy $10 trillion or more.

Gray zone competition falls below the threshold of open warfare but still imposes costs. Cyber attacks on critical infrastructure—the 2021 Colonial Pipeline ransomware attack disrupted fuel supplies to the US East Coast, causing gasoline shortages—hybrid warfare campaigns, economic coercion, and territorial salami-slicing all create uncertainty and risk without triggering formal conflict. China’s construction of artificial islands in the south-china-sea, incrementally establishing control without ever crossing a clear threshold for military response, exemplifies gray zone operations. Such activities have become endemic in relations among major powers, with Microsoft reporting over 1,000 nation-state cyber attacks annually against its customers.

Sanctions and economic statecraft weaponize economic interdependence. Export controls, asset freezes, financial exclusions, and trade restrictions can devastate targeted economies while disrupting global supply chains and creating compliance costs for firms worldwide. The sanctions regimes imposed on Russia after 2022 demonstrated both the power and the reverberating effects of economic warfare: Russia’s economy contracted 2.1% in 2022 and faces long-term diminished growth potential, while European energy prices spiked and global food costs rose 14.3% in 2022. Iran, under sanctions since 1979 with escalation in 2012 and 2018, has seen its GDP decline roughly 60% from pre-sanctions trajectory. North Korea’s economy remains stunted under the world’s most comprehensive sanctions regime.

Political instability and regime change in strategically important countries can upend assumptions about market access, contract enforcement, and policy continuity. The Arab Spring, which toppled governments in Tunisia (January 2011), Egypt (February 2011), Libya (October 2011), and Yemen (2012), illustrated how contagion effects can spread political turmoil across an entire region. Egyptian sovereign bonds lost 40% of their value during the revolution; Libyan oil production fell from 1.6 million barrels per day to near zero during the civil war. Venezuela’s political crisis under Maduro has reduced oil production from 2.4 million barrels per day in 2015 to under 800,000 by 2020, with partial recovery since.

Terrorism and non-state violence pose asymmetric threats. While the direct economic damage from terrorist attacks is typically limited (the September 11 attacks caused approximately $40 billion in direct damage), the indirect effects—increased security costs (the US has spent over $2.5 trillion on homeland security since 2001), reduced tourism (international arrivals fell 40% in affected regions following major attacks), heightened uncertainty—can be substantial. More consequentially, terrorism can trigger overreactions that prove costlier than the attacks themselves: the post-9/11 wars in Afghanistan and Iraq cost an estimated $8 trillion and over 900,000 lives.

Measuring Geopolitical Risk¶

Quantifying something as complex as geopolitical risk presents inherent difficulties. Nevertheless, several approaches have been developed, each with distinct strengths and limitations:

The Geopolitical Risk (GPR) Index, constructed by economists Dario Caldara and Matteo Iacoviello at the Federal Reserve Board, measures risk by counting the frequency of newspaper articles discussing geopolitical tensions, wars, and terrorism in 10 major newspapers including the New York Times, Washington Post, Financial Times, and Wall Street Journal. The index, available from 1900 to the present with daily updates, distinguishes between threats (discussions of risk) and acts (reports of actual events). The GPR Index spiked to its highest level since the 1991 Gulf War following Russia’s 2022 invasion of Ukraine. Research using the GPR Index finds that a one-standard-deviation increase in geopolitical risk reduces investment by 1.8% and predicts stock market returns—elevated risk presages declines while falling risk presages gains.

The ICRG Political Risk Rating, published by the PRS Group since 1980, provides country-level assessments covering 140 countries based on expert evaluations of government stability, socioeconomic conditions, investment profile, internal and external conflict, corruption, military involvement in politics, religious tensions, ethnic tensions, democratic accountability, and bureaucracy quality. Each category receives points on a 100-point scale, with lower scores indicating higher risk. The ratings enable cross-country comparisons and have been used extensively in academic research on political risk and foreign direct investment—studies consistently find that higher ICRG ratings correlate with greater FDI inflows.

Scenario analysis and expert judgment complement quantitative measures. Intelligence agencies, consultancies (Eurasia Group, Control Risks, Oxford Analytica), and corporate risk functions employ regional specialists to assess specific risks, identify key indicators, and develop contingency plans. Eurasia Group’s annual “Top Risks” report has become a widely followed benchmark for geopolitical risk assessment. Such qualitative analysis captures nuances that aggregate indices miss—the 2024 edition, for instance, identified specific scenarios for US-China technology decoupling and Middle East escalation that quantitative indices could not articulate—but depends on the quality and objectivity of the analysts.

Market-implied measures derive risk assessments from asset prices. The spread between sovereign bonds and risk-free benchmarks, implied volatility in options markets, and credit default swap prices all embed market participants’ collective judgment about political risks. Russia’s 5-year CDS spread rose from approximately 100 basis points before the Ukraine invasion to over 4,000 basis points—implying a perceived probability of default approaching certainty. The VIX index, often called the “fear gauge,” spiked 86% in the week following the invasion. These measures are forward-looking and continuously updated but may reflect liquidity conditions and positioning as much as genuine risk assessment—CDS markets for some emerging markets are too thin to provide reliable signals.

Machine learning and alternative data represent emerging approaches. Natural language processing of news, social media, and government documents can identify risk indicators at scale—some hedge funds analyze satellite imagery of military bases, ship traffic through chokepoints, and nighttime light emissions to detect economic and military activity changes before they appear in official statistics. Planet Labs captures imagery of the entire Earth daily; commercial providers track every ship at sea via AIS transponders. These tools promise more timely and granular risk assessment but require careful validation—false positives can be costly, and adversaries may engage in deliberate deception.

Each methodology has limitations. Text-based measures may conflate coverage with risk (events that capture media attention are not necessarily the most consequential); expert judgments reflect biases and blind spots (the intelligence community largely failed to anticipate the 2022 invasion’s timing); market prices can be noisy or distorted (liquidity crises cause spreads to widen regardless of fundamentals). Prudent analysis triangulates across multiple approaches.

Economic Impacts¶

Geopolitical risk affects economies through several channels:

Investment and capital flows respond directly to uncertainty. Firms defer capital expenditures when geopolitical conditions deteriorate; foreign direct investment avoids high-risk jurisdictions; portfolio capital flees to safe havens during crises. Research consistently finds that elevated geopolitical risk reduces investment, with effects persisting for years after shocks subside.

Trade disruption accompanies conflicts and sanctions. Wars close shipping lanes and destroy infrastructure; sanctions prohibit commercial relationships; trade policy weaponization restricts market access. The Strait of Hormuz, Strait of Malacca, and Suez Canal represent chokepoints where geopolitical events could interrupt global commerce.

Commodity prices transmit geopolitical shocks globally. Oil markets have historically been most sensitive—the 1973 embargo, the 1979 Iranian Revolution, the 1990 Gulf War, and the 2022 Russia sanctions all produced price spikes. But agricultural commodities (Ukraine exports grain), industrial metals (Russia produces palladium and nickel), and rare earths (China dominates processing) also carry geopolitical risk premiums.

Financial markets respond to geopolitical events with varying intensity. Academic research finds that stock markets decline on geopolitical shocks but typically recover within weeks unless conflicts escalate. However, realized volatility increases, risk premiums rise, and correlations across assets spike—reducing diversification benefits precisely when they are most needed.

Currency markets reflect safe-haven flows and changing perceptions of country risk. The dollar, Swiss franc, and yen traditionally appreciate during geopolitical crises; emerging market currencies with current account deficits and political vulnerabilities depreciate. Exchange rate movements in turn affect trade competitiveness and balance sheet positions.

Inflation and monetary policy face complications when geopolitical shocks are stagflationary—raising prices while reducing output. Central banks must choose between fighting inflation and supporting growth. The 1970s demonstrated how geopolitical supply shocks can entrench inflation expectations and produce a lost decade.

Risk Management Strategies¶

For investors and corporations, managing geopolitical risk requires systematic approaches:

Diversification remains the first line of defense. Geographic diversification reduces exposure to any single country’s political risk; asset class diversification provides protection when equity-bond correlations break down; supply chain diversification reduces dependence on any single source. The costs of diversification—efficiency losses, complexity, higher prices—must be weighed against the benefits of resilience.

Scenario planning prepares organizations for alternative futures. Rather than forecasting a single outcome, scenario planning identifies critical uncertainties, develops plausible futures, and stress-tests strategies against each. Shell Oil’s scenario planning famously anticipated the 1973 oil shock, enabling faster adaptation than competitors.

Political risk insurance transfers specific risks to specialized insurers. Coverage is available for expropriation, political violence, currency inconvertibility, and contract frustration. Multilateral agencies (MIGA, OPIC) and private insurers offer policies that enable investment in higher-risk jurisdictions.

Hedging instruments provide financial protection. Currency forwards and options protect against exchange rate movements; commodity futures lock in prices; credit default swaps insure against sovereign default. However, hedging instruments may become unavailable or prohibitively expensive precisely when risks materialize.

Real options thinking values flexibility. Investments that can be scaled up, delayed, or abandoned as conditions change are worth more in volatile environments than rigid commitments. Structuring investments with optionality—even at some cost to expected returns—enhances resilience.

Monitoring and early warning enable timely response. Tracking leading indicators—military deployments, diplomatic developments, domestic political dynamics—provides advance notice of changing conditions. Organizations with superior information and faster decision processes can act before risks crystallize.

Current Hotspots¶

Several regions concentrate geopolitical risk as of early 2026:

Taiwan and the Western Pacific represent the most consequential flashpoint. A Chinese attempt to achieve reunification by force would trigger direct conflict between nuclear-armed great powers, disrupt global semiconductor supply chains (TSMC produces over 90% of the world’s most advanced chips, with a single Taiwanese facility—Fab 18—producing the majority of leading-edge 3nm chips), and reshape the international order. Bloomberg Economics estimated a Taiwan conflict scenario could reduce global GDP by 10.2%—roughly $10 trillion—dwarfing the COVID-19 pandemic’s economic impact. The probability remains low in any given year—most analysts estimate single-digit annual probabilities—but the consequences are severe enough to dominate risk calculations. Xi Jinping’s consolidation of power, PLA modernization timelines, and explicit statements that Taiwan’s status “cannot be passed down generation after generation” create uncertainty about China’s patience.

Russia and Eastern Europe remain unstable. The war in ukraine continues into its fourth year, with uncertain prospects for escalation, frozen conflict, or negotiated settlement. Russia has suffered estimated casualties exceeding 300,000 (killed and wounded); Ukraine’s losses, while lower, have strained its military manpower. NATO’s eastern flank faces ongoing gray zone pressure—hybrid attacks, information warfare, and potential sabotage of critical infrastructure. Russian instability itself poses risks—what happens after Putin remains an open question, with scenarios ranging from managed succession to power struggle to state fragmentation, each carrying distinct implications.

The Middle East has seen renewed instability since October 2023. The Israel-Hamas war and subsequent regional escalation—Iranian missile attacks on Israel, Israeli strikes on Iranian territory, Hezbollah’s involvement, and Houthi attacks on red-sea shipping—have demonstrated how quickly Middle Eastern conflicts can cascade. Houthi attacks have disrupted 15-20% of global container shipping that normally transits the Red Sea and Suez Canal, forcing rerouting around Africa with 10-14 day delays and significantly higher costs. Iranian-Israeli tensions and the potential for wider regional war create interlocking risks. The region’s energy resources—Saudi Arabia, Iraq, UAE, Kuwait, and Iran collectively produce roughly 25% of global oil—ensure that Middle Eastern instability reverberates globally.

The South China Sea witnesses daily friction. Chinese Coast Guard vessels harass Philippine supply missions to contested features like Second Thomas Shoal; China has deployed water cannons and engaged in dangerous maneuvers. American freedom of navigation operations contest Chinese claims; approximately 12 such operations occur annually. The overlapping claims of six states (China, Taiwan, Vietnam, Philippines, Malaysia, Brunei) create conditions for miscalculation. Roughly $3.4 trillion in trade transits these waters annually; any conflict would disrupt the arteries of Asian commerce.

Technology and economic competition between the United States and China increasingly resembles geoeconomic warfare. The October 2022 semiconductor export controls—subsequently tightened in 2023 and 2024—restrict China’s access to advanced chips and manufacturing equipment. Chinese retaliation on gallium, germanium, and rare earth processing technologies signals escalation capacity. Investment restrictions (CFIUS review of Chinese investments, Chinese restrictions on foreign firms), subsidy races (CHIPS Act versus Made in China 2025), and standards competition (5G, AI governance) are fragmenting the global economy into competing blocs—a structural condition that elevates risk across all other domains. The IMF warns that “geoeconomic fragmentation” could reduce global output by up to 7% over the long term.

Geopolitical risk cannot be eliminated; it is a permanent feature of a world organized into sovereign states with divergent interests. But it can be understood, measured, and managed. For those who take it seriously, geopolitical risk analysis provides not certainty—that is impossible—but preparation for an uncertain future. As the world enters a period of heightened great power competition, the ability to anticipate, assess, and adapt to geopolitical shocks will distinguish successful investors, companies, and nations from those caught unprepared.

Sources & Further Reading¶

• Measuring Geopolitical Risk by Dario Caldara and Matteo Iacoviello — The Federal Reserve Board economists’ technical paper introducing the GPR Index, which has become a standard measure of geopolitical risk in academic and policy research.

• Political Risk: How Businesses and Organizations Can Anticipate Global Insecurity by Condoleezza Rice and Amy Zegart — A former secretary of state and Stanford professor provide a framework for understanding and managing political risks, with cases from corporate experience.

• The Art of the Long View by Peter Schwartz — The foundational text on scenario planning as a tool for navigating uncertainty, drawing on the author’s experience at Royal Dutch Shell.

• Risk: A Very Short Introduction by Baruch Fischhoff and John Kadvany — Provides broader context for understanding how humans perceive and respond to risk, essential background for interpreting geopolitical risk assessments.