The growing impact of political risk on financial markets

Political risk is increasingly driving financial markets. Government coalitions fail and snap elections are called. Tariff wars reshape global supply chains. The conflicts in Ukraine and the Gulf disrupt commodity flows. The United States pushes a coercive foreign policy over Greenland¹. But what exactly is political risk, and how can it be measured? What effect does it have on financial markets and can investors and policymakers protect themselves from such effects?

What is political risk? It’s complicated

Political risk is an often-used but hard-to-define concept. The classic definition (Robock, 1971) is that political risk arises from discontinuities in the business environment that are difficult to anticipate and result from political change. But political change at country level – for example snap elections in France, as seen in mid-2024, or the MAGA turn in the US – has many causes, and there is no agreed metric of political signals (Sottilotta, 2016)². One measure of political risk is the International Country Risk Guide (ICRG)³, which provides a weighted-average rating encompassing corruption, bureaucratic quality, investment profile, socioeconomic conditions, religious tensions, ethnic tensions, military in politics, internal and external conflicts, law and order and democratic accountability.

Political risk thus originates from political decisions and events. Several measures have been developed to assess country-level political risk. Table 1 summarises selected measures that seek to capture multifaceted political risk using methods including surveys, expert opinion and news analytics.

Table 1: Political risk ratings differ in definition and methodology

^{Source: Bruegel. Note: see below for details of ratings and their publishers.}

Are political risk ratings reliable?

Political risk ratings (Table 1) both differ and overlap, and do not move in tandem. They have diverged substantially over time (see Figure A1 in the annex), with the divergence more pronounced during periods of large ratings movements. In other words, raters of political risk disagree more when their ratings are most needed to understand political risk.

Nevertheless, these ratings have been shown to be valid and are used widely⁴. ICRG ratings, on average, predicted events that triggered political risk insurance claims to the Overseas Private Investment Corporation (previously the US’s development finance institution) (Bekaert et al, 2014). The Economic Policy Uncertainty index (EPU) has been shown to correlate closely with mentions of policy uncertainty in the US Federal Reserve System’s Beige Books, or reports on economic conditions (Baker et al, 2016). The Geopolitical Risk Index (GPR) provides a plausible quantification of the historical and geographical evolution of geopolitical risks (Caldara and Iacoviello, 2022). Ifo WES ratings have been validated as truly capturing political risk, rather than a variety of other economic and financial ratings that also move markets (Gala et al, 2023).

Political risk is priced – and it’s everywhere

Country-level political risks, arising during elections, may have spillover effects onto global markets. But focusing on individual events and their spillovers misses an important point: country-level political risk usually increases before an extreme event, which may or may not materialise. For instance, political risk increases ahead of a national election and the increase can be greater if the incumbent faces a serious challenger. The political risk ratings shown in Figure 1 capture these changes.

Importantly, political risk has also been shown to have a strong, global, systematic component that cuts across countries (Gala et al, 2023). In other words, it is not only national events that can increase political risk through their ripple effects (such as Hungary’s 12 April election result having ramifications for the European Union as a whole)⁵. Broader political trends of waves of sentiment – such as an increased global turn to liberalism, populism or authoritarianism – also have a substantial impact on global political risk. Gala et al (2025) found that more than 50 percent of the variability in the ICRG country ratings across a sample of 42 developed and emerging markets can be explained by a common factor (see Figure A1 in the annex). This suggests that political risk ratings reflect country exposures to systematic global changes, rather than merely idiosyncratic country characteristics.

Working from this observation we constructed, using standard asset-pricing tools, a global political risk factor (GP) for the financial markets, intended to capture broader changes in political trends. We found that standard asset-pricing models do not capture this risk factor. A two-factor model of the global market portfolio and GP explains about three-quarters of the cross-sectional differences in returns, both within and across asset classes. When political risk is included using GP, just two factors do the heavy lifting that would usually require many more. The return on GP is 4.44 percent annually. Investment performance significantly outstrips the global market average⁶. Investors can reap significant benefits by harvesting political risk premia in addition to standard market risk premia. 

The global political risk factor operates not only within each major asset class but also jointly across asset classes (Gala et al, 2025). Sorting countries by political risk produces a consistent pattern across equities, bonds and currencies. A portfolio that goes long in countries with low political risk ratings and short in those with high political risk ratings yields dollar-denominated return spreads of about 6 percent in equities, 4 percent in bonds and 4.5 percent in currencies. These, again, compare favourably with the average return of 3.83 percent of a global multi-asset market portfolio.

Crucially, GP shows that political risk cannot be eliminated through cross-country diversification. Investment in politically riskier countries would not earn higher returns if investors could diversify away country-specific political risk through an international portfolio; one-off diversifiable risks do not command a risk premium. GP represents a systematic component of global risk rather than an idiosyncratic, and hence diversifiable, country-specific disturbance. But it also affects all asset classes, implying that it cannot be diversified away by investing in different assets.

Figure 1 shows that GP (red) closely tracks a composite global political risk rating derived from experts’ surveys (blue), capturing major political events. GP establishes that political risk is systematic (half of the variability of political risk ratings can be explained by a common factor), significant (shown by the large premia) and broad reaching (shown by premia on stocks, bonds and currencies)⁷.

Figure 1: Global political rating index, GP and political events

^{Source: Gala et al (2025). Note: changes (normalised) in the global political risk factor are highly correlated with changes in a global political rating, averaging the political risk ratings of 42 countries, and react to major country-level events.}

Policy implications

The political risk factor is an increasingly strong driver of financial markets (Gala et al, 2025). Its importance in the global pricing model has roughly doubled since the early 2000s (see Figure A2 in the annex). This finding lends empirical support to the widespread perception that the geopolitical order is becoming increasingly fragmented. Identifying changes in political trends as a global systemic risk factor in markets has practical implications for governments and investors.

Policymakers must consider the higher borrowing costs implied by the pricing of political risk in bond premia. For instance, a 10-point decline on the ICRG’s 100-point scale (ie an increase in political risk) increases sovereign bond yields by 106 basis points, on average (Ajovalasit et al, 2025). This has implications for debt sustainability; international institutions, the European Commission and country debt-management offices should explicitly incorporate political risk into forward-looking debt-sustainability analyses. Given the multi-dimensional nature of political risk and the low agreement between political-risk ratings, multiple ratings should be adopted for a robust, comprehensive assessment of political risk.

Investors recognise that political risk cannot be easily diversified away, neither across countries nor asset classes. Using portfolio optimisation strategies, political risk can be minimised or even hedged in some cases (Lotfi et al, 2025). However, portfolios hedged against one aspect of political risk may remain heavily exposed to others. Reliance on a single political risk rating leaves investors exposed to risks that specific measures underemphasise. Risk management requires robust approaches spanning multiple ratings. Once properly identified, political risk can be properly managed. 

References

Ajovalasit, S., A. Consiglio, G. Pagliardi and S. A. Zenios (2025) ‘Are bad governments a threat to sovereign defaults? The effects of political risk on debt sustainability’, Working Paper 01/2025, Bruegel, available at https://www.bruegel.org/sites/default/files/2025-01/WP%2001%202025_0.pdf

Baker, S.R., N. Bloom and S.J. Davis (2016) ‘Measuring economic policy uncertainty’, The Quarterly Journal of Economics 131: 1593-1636, available at https://doi.org/10.1093/qje/qjw024

Bekaert, G., C.R. Harvey, C.T. Lundblad and S. Siegel (2014) ‘Political risk spreads’, Journal of International Business Studies 45: 471-493, available at https://doi.org/10.1057/jibs.2014.4

Caldara, D. and M. Iacoviello (2022) ‘Measuring geopolitical risk’, American Economic Review 112: 1194-1225, available at https://doi.org/10.1257/aer.20191823

ESRB and ECB (2026) Financial Stability Risks from Geoeconomic Fragmentation, European Systemic Risk Board and the European Central Bank, available at https://www.ecb.europa.eu/pub/pdf/other/ecb.report202601_financialstabilityrisks.en.pdf

Gala, V.D., G. Pagliardi and S.A. Zenios (2023) ‘Global political risk and international stock returns’, Journal of Empirical Finance 72: 78-102, available at https://doi.org/10.1016/j.jempfin.2023.03.004

Gala, V.D., G. Pagliardi, I. Shaliastovich and S.A. Zenios (2025) ‘Political Risk Everywhere’, mimeo, available at https://dx.doi.org/10.2139/ssrn.4674860

Lotfi, S., G. Pagliardi, E. Paparoditis and S. A. Zenios (2025) ‘Hedging political risk in international equity portfolios’, European Journal of Operational Research 322(2): 629-646, available at https://doi.org/10.1016/j.ejor.2024.10.017

Robock, S.H. (1971) ‘Political risk: Identification and assessment’, Columbia Journal of World Business 6(4): 6–20, available at 

Sottilotta, C. (2016) Rethinking Political Risk: Concepts, Theories, Challenges, Taylor & Francis

Annex: Variation in political risk ratings

A simple statistic (Krippendorff alpha), which measures overall agreement, gives a cross-country average of up to 0.25 across the political risk ratings in Table 1; this is well below the agreement threshold of 0.667. Figure A1 shows the political risk ratings for a sample of 42 developed and emerging countries spanning 1992-2019. We take PRI, the aggregate of ICRG, as the reference since it has the highest correlation with the other ratings.

Figure A1: Political ratings do not move in tandem

^{Source: Bruegel. Note: the figure displays the ratings using six different methods from Table 1 for 42 developed and emerging markets spanning 1992 to 2019. The x-axis is the political risk index from ICRG. The y-axis displays the ratings for the five alternatives. If they were perfectly aligned, all the points would be on a 45-degree line.}

Figure A2: Principal components of cross-country political risk ratings

^{Source: Gala et al (2025). Note: the cumulative percentage of variance explained, respectively, by the first (red) and the first three principal components on the ICRG political risk ratings (blue). Principal components analysis is run on a set of 42 developed and emerging markets spanning 1992 to 2019.}

The price of global political risk has risen substantially since the mid-2000s relative to global market risk.

Figure A3: The price of the global market risk factor and the global political risk factor

^{Source: Gala et al (2025). Note: risk prices are computed as factor risk premium scaled by variance.}

The opinions expressed in this paper are those of the authors and not of the institutions they are affiliated with.