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. Stock markets crashed. 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.
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; 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.
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.
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.
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.
Types of Geopolitical Risk¶
Analysts typically distinguish several categories:
Interstate conflict remains the most severe form. War destroys capital, disrupts trade, displaces populations, and consumes government resources. Even short of actual combat, military tensions raise risk premiums, deter investment, and divert resources to defense. 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.
Gray zone competition falls below the threshold of open warfare but still imposes costs. Cyber attacks on critical infrastructure, hybrid warfare campaigns, economic coercion, and territorial salami-slicing all create uncertainty and risk without triggering formal conflict. Such activities have become endemic in relations among major powers.
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.
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 across the Middle East, illustrated how contagion effects can spread political turmoil across an entire region.
Terrorism and non-state violence pose asymmetric threats. While the direct economic damage from terrorist attacks is typically limited, the indirect effects—increased security costs, reduced tourism, heightened uncertainty—can be substantial. More consequentially, terrorism can trigger overreactions that prove costlier than the attacks themselves.
Measuring Geopolitical Risk¶
Quantifying something as complex as geopolitical risk presents inherent difficulties. Nevertheless, several approaches have been developed:
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. The index, available from 1900 to the present, distinguishes between threats (discussions of risk) and acts (reports of actual events). Research using the GPR Index finds that elevated geopolitical risk reduces investment, increases uncertainty, and predicts stock market declines.
The ICRG Political Risk Rating, published by the PRS Group, provides country-level assessments based on expert evaluations of government stability, socioeconomic conditions, investment profile, internal and external conflict, corruption, military involvement in politics, and other factors. The ratings enable cross-country comparisons and have been used extensively in academic research on political risk and foreign direct investment.
Scenario analysis and expert judgment complement quantitative measures. Intelligence agencies, consultancies, and corporate risk functions employ regional specialists to assess specific risks, identify key indicators, and develop contingency plans. Such qualitative analysis captures nuances that aggregate indices miss 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. These measures are forward-looking and continuously updated but may reflect liquidity conditions and positioning as much as genuine risk assessment.
Machine learning and alternative data represent emerging approaches. Natural language processing of news, social media, and government documents can identify risk indicators at scale. Satellite imagery tracks troop movements and economic activity. Mobile phone data reveals population flows. These tools promise more timely and granular risk assessment but require careful validation.
Each methodology has limitations. Text-based measures may conflate coverage with risk; expert judgments reflect biases and blind spots; market prices can be noisy or distorted. 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 2025:
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 most advanced chips), and reshape the international order. The probability remains low in any given year, but the consequences are severe enough to dominate risk calculations.
Russia and Eastern Europe remain unstable. The war in Ukraine continues, with uncertain prospects for escalation, frozen conflict, or negotiated settlement. NATO’s eastern flank faces ongoing gray zone pressure. Russian instability itself poses risks—what happens after Putin remains an open question.
The Middle East has seen renewed instability since October 2023. Iranian-Israeli tensions, proxy conflicts, Houthi attacks on Red Sea shipping, and the potential for wider regional war create interlocking risks. The region’s energy resources ensure that Middle Eastern instability reverberates globally.
The South China Sea witnesses daily friction. Chinese assertiveness, Philippine resistance, American freedom of navigation operations, and the overlapping claims of multiple states create conditions for miscalculation. The vital shipping lanes transiting the region magnify the stakes.
Technology and economic competition between the United States and China increasingly resembles geoeconomic warfare. Export controls, investment restrictions, subsidy races, and standards competition are fragmenting the global economy into competing blocs—a structural condition that elevates risk across all other domains.
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.