Judge how stock markets reacted to various domestic and global geopolitical risk events, such as Russia's invasion of Ukraine and U.S.-China trade tensions, and account for their spillovers across borders.
The idea
Stock market reactions are studied with event windows. The abnormal return is the actual return minus the return expected from a model. In symbols, the abnormal return for the event window is the following. Abnormal = actual return − expected return. A market model sets the expected return as follows, with intercept α and sensitivity β. Expected = α + β × market return. Both domestic and global events matter. Domestic events hit the local market hardest, while global events such as Russia's invasion of Ukraine in February 2022 or the escalation of U.S.-China trade tensions lower equity prices in many countries at once, by more where trade, energy and financial links to the affected parties are strong. Spillovers travel through trade, supply chains, commodity prices, financial linkages and investor sentiment. Remember that a narrow window can understate the reaction if the event was anticipated, because part of the repricing happened earlier. The exam point is that spillover size follows exposure, not distance alone.
Formulas
Abnormal return in a market-model event study
AR = R − (α + β × Rm)
- R
- the actual return on the event day
- α
- the market-model intercept
- β
- the market-model beta
- Rm
- the market return on the event day
A narrow window understates the reaction if the event was anticipated, because part of the repricing came earlier.
A practice question
In an event study, the market model gives expected return = alpha + beta x market return, with alpha = 0 and beta = 1.2. On the event day an equity index falls 4.0% while the broad market falls 2.5%. The abnormal return is closest to:
- -1.5%Why not: Uses beta equal to 1, giving -4.0 - (-2.5) rather than the stated beta of 1.2.
- +1.0%Why not: Reverses the order, taking expected minus actual return.
- -4.0%Why not: Treats the raw return as abnormal, ignoring the market movement.
- -1.0% - correct
Expected return = 1.2 x (-2.5%) = -3.0%. Abnormal return = actual - expected = -4.0% - (-3.0%) = -1.0%.
A harder one
Comparing domestic and global geopolitical events, which pattern is most consistent with the evidence on stock market reactions?
- Domestic events mainly hit the local market; global events lower prices in many markets by differing amounts. - correct
- Domestic events affect all markets around the world equally, while global events affect only the home country.Why not: Reverses the pattern of local versus widespread effects.
- Global events leave stock markets largely unaffected because they are widely diversified away by investors.Why not: Systematic events cannot be diversified away and move many markets.
- Both types of events produce identical reactions in every market.Why not: Denies heterogeneity; size depends on exposure and linkages.
Domestic risk concentrates its impact at home. Global events spread across borders, with magnitude depending on trade, energy and financial exposure.
The hardest tier
After a trade-tension event, Country A's equity index falls 6%. Country B's index has a spillover coefficient of 0.25 to Country A, meaning it moves 0.25 percent for each 1 percent move in A. Country B also has a separate domestic shock of -1%. Assuming the effects add, B's predicted return is closest to:
- -2.5% - correct
- -1.5%Why not: Includes only the spillover from Country A and ignores the domestic shock.
- -7.0%Why not: Adds A's full 6% fall to B's domestic shock, ignoring the 0.25 coefficient.
- -1.75%Why not: Applies the 0.25 coefficient to the sum of A's fall and the domestic shock instead of only to A.
Spillover = 0.25 x (-6%) = -1.5%. Adding the domestic shock: -1.5% + (-1%) = -2.5%. The coefficient applies only to the foreign shock.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Global Financial Stability Report, Chapter 2
- Pinpoint the main routes by which geopolitical risk moves asset prices and affects financial stability, and review policy responses to its possible fallout.
- Examine why geopolitical risk events worldwide leave different marks on individual countries, industries and asset classes, notably separating net commodity importers from exporters.
- Judge the way geopolitical shocks feed into the premiums demanded for holding sovereign risk.
- Show how equity and option markets price in geopolitical risk, including shifts in downside risk and tail-risk premiums.
- Outline how being exposed to geopolitical risk shapes how well banks and non-bank financial firms hold up, through share valuations, credit supply and flows into investment funds.