1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5.

Firm-Level Effects Conclusions

Measuring Geopolitical Risk

Dario Caldara Matteo Iacoviello

Federal Reserve Board

October, 2021 - West Virginia University

Disclaimer: The views expressed are solely the responsibility of the authors and should not be interpreted as reflecting the
views of the Board of Governors of the Federal Reserve System or of anyone else associated with the Federal Reserve System.
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Geopolitical Risks Receive a Lot of Attention

Geopolitical risks are often cited by policy-makers, investors, and media as

key determinants of economic decisions.

75% of investors worry about geopolitical risk (Gallup Survey 2017).

Geopolitical risk salient risk to outlook for BoE, ECB, IMF, WB.

Higher geopolitical risks can:

1. Heighten perception of disastrous outcomes
2. Make investment in risky projects less attractive.
3. Lower consumer confidence

Do Geopolitical Risks Have Economic Consequences?

How Do We Measure Them?
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

What We Do: Definition and Measurement

1. Construct text-based indicator of geopolitical risk—GPR

Index—measuring frequency of articles in leading newspapers
discussing adverse geopolitical events.
I Focus on wars, terrorism, tensions between states;

2. Separate threats of adverse geopolitical events from their realization

and escalation.

GPR Index highly correlated with narrative measure of geopolitical risk.

GPR Index correlated with firms’ own assessment of geopolitical risks.

1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

What We Do: Empirical Evidence

Aggregate analysis:
Higher GPR reduces investment, employment, and stock returns.
Effects driven both by threat of adverse geopolitical events and by
their realization.

Higher GPR is also associated with increased probability of disaster

outcomes, and has large effects on the tail of the GDP distribution.

Firm-level analysis:
Reduction in firm-level investment stronger for firms highly exposed to
aggregate GPR.
Idiosyncratic GPR reduces firm-level investment
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Definition: Geopolitics and Geopolitical Risk

Geopolitics: how geography affects politics and relations among

states.

Geopolitical Risk is the threat, realization, and escalation of adverse

events associated with wars, terrorism, and any tensions among states
and political actors that affect the peaceful course of international
relations.
The GPR index is a continuous measure of risk. Higher values
measure:
I higher current intensity of negative events (e.g. more wars)
I higher probability of negative events in the future
I higher expected intensity of future negative events
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Measurement: Newspaper Searches

The geopolitical risk (GPR) index is measured by the frequency of

newspaper articles discussing adverse geopolitical events.

G
GPR ∝
U
G : articles mentioning adverse geopolitical events;
U : total number of articles
Recent index (from 1985): Chicago Tribune; Los Angeles Times;
NYT; WSJ; WaPo; Phil.Enquirer; Daily Telegraph; FT; Guardian; The
Globe and Mail.

Historical index (since 1900): NYT, Chicago Tribune, and WaPo

Risks as covered/perceived by the English-speaking press.

1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Measurement: Selecting Terms in set G

We create query comprising two bags of words, the first bag containing
topic words (e.g. war words, nuclear words, terrorism words), the
second bag containing either “threat” or “act” words for each topic.

The selection of topic words is based on:

I definition of the phenomenon itself;
I human reading and textual analysis of 44,000 front pages of NYT from
1900 through 2020;
I extensive analysis of key dates and language used by the newspapers of
that period in describing geopolitical events and their synonyms.

Notes:
I We exclude from searches articles containing words (such as movie,
anniversaries, obituaries, books) associated with false positives.
I We account for the evolution of language over time.
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

The Search Terms

1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

The Search Terms

1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

The Historical Geopolitical Risk Index

WWII
500 WWI Begins
Begins D−Day
Pearl
Harbor

WWI
Escalation

400

September 11
300
Korean Gulf War Iraq
War War
Germany Cuban Crisis
Invades
Czechia Iraq
Berlin Invades
200 Italy−
Ethiopia Problem
Six Day
War Yom
Kuwait
Falklands
Suez
War Kippur War
Crisis
War Afghan
Russia−Japan Invasion Paris
War Terror
Attacks
Shanghai
Boxer Incident
Rebellion
Bosnian
100 Occupation
of Ruhr War

0
1900 1920 1940 1960 1980 2000 2020
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

The Recent Geopolitical Risk Index

600
September 11

400 Gulf War

Iraq War

Iraq
Invades
Kuwait

200 London
Bombings
U.S. Bombing Paris
Libya U.S.−
Attacks N.Korea U.S.−
Interv. Iran
Airstrikes Libya Russia Tensions Tensions
on Iraq Annexes
Crimea
Bosnian
War

100

50

1985 1990 1995 2000 2005 2010 2015 2020

GPR available at https://www.matteoiacoviello.com/gpr.htm

1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Geopolitical Threats vs. Geopolitical Acts

GPR index captures a convolution of shocks to various moments of

the distribution of geopolitical events.

We break the index down into:

I Geopolitical Threats (GPT): Search categories 1 to 5;
I Geopolitical Acts (GPA): Search categories 6 to 8.

Main idea: Many spikes in GPT and GPA associated with realization
of geopolitical acts...

... Yet, some movements in GPT may happen when no underlying act
materializes.
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Geopolitical Threats vs. Geopolitical Acts

World War I World War II Early 1960s

800 D−Day 400 Cuban Crisis
600 WWI Begins
Pearl Harbor
Berlin Problem
US Enters War 600 WWII begins 300
400
Germany
400 Invades 200
Czechia
Occupation
200 Vera Cruz
200 100

0 0 0
1913 1915 1917 1919 1938 1940 1942 1944 1961 1962 1963 1964

Gulf War 9/11 and Iraq War 200 2016−2020

Kuwait Invasion
500 9/11 US−Iran
Gulf War
300 150 US−North Korea
400
Iraq War
200 300 100
200
100 50
100

0 0 0
1989 1990 1991 1992 2001 2002 2003 2004 2016 2017 2018 2019 2020
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Is the Index Plausible?

Does the Index Pass a Plausibility Test?

Could Changes in the Use of Language Matter?

How Does the Index Compare with Other Indicators of Conflict and
War News?
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Newspaper Headlines
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

The Narrative GPR Index

We read 44,000 daily front pages of NYT and code them 0, 1, 2, or 5
depending on coverage of geopolitical events
600
WWI
Escalation
Narrative GPR
D−Day Historical GPR
WWII
Begins
WWI
Begins

400

Gulf Iraq War

War
9/11
Korean
War Fall of
Saigon Falklands
Suez Cuban War
Italy− Crisis Crisis
Ethiopia Paris
Russia−Japan War Terror
Attacks
200 War

0
1900 1920 1940 1960 1980 2000 2020
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Use of Words over Time

Risk
15

Fear
Warning

Danger
10

Doubt
Dispute
5

Menace
Peril
0

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020
10

War/4 Risk
15

Fear
Warning
8

Danger
610

Terrorism
Doubt
Guerrilla
2 5 4

Dispute
Military
Conflict+Hostilities
Revolutions
Menace
00

Peril
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

GPR and Other War Indicators

80 400
Mil. News (% of GDP), left scale
60 GPR (quarterly), right scale
300
40
200
20

100
0

−20 0
1900q1 1920q1 1940q1 1960q1 1980q1 2000q1 2020q1

350 400
80 War Deaths (per 100,000), left scale 400
Mil. News (% of GDP), left scale
300 GPR (annual), right scale
60 GPR (quarterly), right scale
250 300
300
200
40
200
150 200
20
100 100
100
0
50
0 0
−20 0
1900 1920 1940 1960 1980 2000 2020
1900q1 1920q1 1940q1 1960q1 1980q1 2000q1 2020q1

350 400
NOTE: Time-Series
300
Comparison of GPR IndexWarand GPR
Deaths shocks
(per 100,000), with Military
left scale
GPR (annual), right scale
News variable
250 from Ramey (2011) and with war deaths. 300
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Geopolitical Risk and Economic Activity

1. VAR Evidence for the United States since 1985: Threats matter as
much as acts

2. Panel Regressions since 1900: GPR predicts economic disasters across

countries

3. Panel Quantile Regressions since 1900: How GPR affects distribution

of economic variables across countries
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Quarterly VARs: Threats and Acts

GPR Specification: LGPR, VIX, BFI, EMP, S&P500, OIL, T02YR.

Acts vs. Threats: Replace LGPR with LGPA & LGPT

Identification (I): Cholesky with GPR indexes ordered before economic

variables ⇒ Contemporanous exogeneity.
Identification (II): LGPA ordered 1st and LGPT 2nd in Cholesky
I GPA shocks capture realization of adverse geopolitical events.
I GPT shocks capture higher threat of adverse geopolitical events.

Sample: 1985Q1-2019Q4
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Quarterly VAR: 2-SD GPR Shock

GPR VIX Private Fixed Investment Hours

50 3 1

40 2 2
0.5

30 1
Percent

Percent

Percent
0 0
Index 0
20
-0.5
-1
10 -2
-2 -1
0
-3 -4 -1.5
0 4 8 12 0 4 8 12 0 4 8 12 0 4 8 12
Quarters Quarters Quarters Quarters
S&P 500 Oil Price Two-Year Yield NFCI Index
10 0.5 0.2

Percentage Points
0 0.1
Percent

Percent

Index
0 0
-5
-5
-0.1
-10

-10 -15 -0.5 -0.2

0 4 8 12 0 4 8 12 0 4 8 12 0 4 8 12
Quarters Quarters Quarters Quarters
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Quarterly VAR: 2-SD GPA Shock

GPR Acts GPR Threats Private Fixed Investment Hours

1
60 Act shock 60 2
Act w/ fixed threat 0.5

40 40
Percent

Percent

Percent
Index
0 0

20 20 -0.5
-2
-1
0 0
-4 -1.5
0 4 8 12 0 4 8 12 0 4 8 12 0 4 8 12
Quarters Quarters Quarters Quarters
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Quarterly VAR: 2-SD GPT Shock

GPR Acts GPR Threats Private Fixed Investment Hours

1
60 Threat shock 60 2
Threat w/ fixed acts 0.5

40 40
Percent

Percent

Percent
Index
0 0

20 20 -0.5
-2
-1
0 0
-4 -1.5
0 4 8 12 0 4 8 12 0 4 8 12 0 4 8 12
Quarters Quarters Quarters Quarters
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Geopolitical Risk and Economic Activity

1. VAR Evidence for the United States since 1985: Threats matter as
much as acts

2. Panel Regressions since 1900: GPR predicts economic disasters across

countries

3. Panel Quantile Regressions since 1900: How GPR affects distribution

of economic variables across countries
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Geopolitical Risk and Tail Risks

Does GPR affects probability of economic disaster / conditional
distribution of macroeconomic variables? Yes

We use yearly data for a panel of 26 countries. Sample runs from

1900 through 2019.

For each country, we construct a country-specific measure of

geopolitical risk controlling for relative intensity of GPR in that
country.
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Country-Specific GPR
GPRC: share of articles simultaneously: (1) mentioning GPR and (2) naming
country in question.
USA GBR
WWI
20.0
10.0 WWII
WWI WWII

15.0 8.0
9/11 6.0
10.0 Korea Cuba Gulf Iraq

4.0 Suez Crisis

Falklands Iraq
5.0
2.0

0.0 0.0
1900 1920 1940 1960 1980 2000 2020 1900 1920 1940 1960 1980 2000 2020

JPN RUS
8.0 Pearl Harbor 6.0 WWI
Cuba

Hiroshima
6.0 WWII
Afghan Inv.
4.0RUS−JPN War
Yom Kippur War
4.0RUS−JPN War Revolution
Gulf War
Shanghai Inc.
Ukraine Annex.
WWI Korean War 2.0
2.0

0.0 0.0
1900 1920 1940 1960 1980 2000 2020 1900 1920 1940 1960 1980 2000 2020
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Country-Specific GPR (continued)

GPRC: share of articles simultaneously: (1) mentioning GPR and (2) naming
country in question.
DEU KOR
15.0 8.0
WWI Korean War

WWII 6.0
10.0
D−Day

4.0
Germany occupies Czechia
5.0
Berlin Crisis 2.0 Flight007
Nucl.Crisis

0.0 0.0
1900 1920 1940 1960 1980 2000 2020 1900 1920 1940 1960 1980 2000 2020

MEX CHN
Carrizal
4.0 Korean War
4.0 McArthur Inquiry
Vera Cruz
3.0
Sino−Jap.War
Shanghai Inc.
3.0
Indo−Pak.War

2.0 Revolution
2.0

Huerta Rebell. Tienanmen

1.0 1.0

0.0 0.0
1900 1920 1940 1960 1980 2000 2020 1900 1920 1940 1960 1980 2000 2020
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Geopolitical Risk and Economic Disasters

Is high GPR associated with higher probability of economic disaster?
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Geopolitical Risk and Quantile Regressions

Does GPR affects the shape of the conditional distribution of
macroeconomic variables?
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Firm-Level Effects of Geopolitical Risk

Two questions:
I Do firms in industries more exposed to aggregate geopolitical risks
experience a larger decline in investment? Yes
I Are there idiosyncratic geopolitical risk events that drive variation in
investment at the firm level? Yes

Conceptual framework:

GPRi,t = GPRt + GPRt Λk + Zi,t .

I Λk is industry-exposure to aggregate GPR

I Zi ,t is idiosyncratic geopolitical risk.
I Goal: To measure the effects of GPRt Λk and Zi ,t on firm investment
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Industry Effects of Geopolitical Risk

Construction of Industry Exposure

Construct stock-market based measure of Fama-French 48-group

industry exposure to geopolitical risk using daily regressions of
industry excess returns on GPR:
Rk,t = αk + β k ∆GPRt + ε k,t ,

Λk = −sign β k − β

I More exposed (negative beta): Entertain, Transportation, Textiles.

I Less exposed (positive beta): Gold, Oil, Defense.

We estimate:
log iki,t +2 = αi [+αt ] + β h (Λk ∆ log GPRt ) + d X i,t + ε i,t +2 (1)
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Firm-Level Effects of Geopolitical Risk

Construction of Firm-Level Exposure

Two steps:

1. Search the earnings call transcripts for geopolitical (GP) terms

I E.g., war*, militar*, terror*, conflict*
I Frequency of GP matches indicates the intensity of geopolitical risks in
a conference call

2. Search transcripts for risk (R) terms in close proximity to GP terms

I E.g., risk*, threat*, tension*, attack*
I Must appear within 10 words

GPRi , t = Number of joint instances of GP and R (normalized by

number of words in the call)
1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Firm-Level GPR on Investment

Estimate:
log iki,t +2 = αi + αk,t + γ Zi,t + d X i,t + ε i,t +2 (2)

αi and αk,t : firm and industry-time fixed effects

γ: response of log ik in t + 2 to change in firm-level GPR (Zi,t ) in
quarter t

Xi,t : firm cash flows and Tobin’s Q, log iki,t −1 .

1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Effects of GPR at firm level

1. Introduction 2. Construction 3. Validation 4. Aggregate Effects 5. Firm-Level Effects Conclusions

Conclusions

Geopolitical risk has adverse negative effects on real activity

I The effect on investment varies across firms and industries.

Adverse effects of geopolitical risk are driven by the threat and

realization of adverse geopolitical events.

On our GPR webpage—together with all data for the US—you can
also find GPR index for many other countries.