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Geopolitical Risk Hedging Strategies

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Written By
Dan Buckley
Contributor Image
Written By
Dan Buckley
Dan Buckley is an US-based trader, consultant, and part-time writer with a background in macroeconomics and mathematical finance. He trades and writes about a variety of asset classes, including equities, fixed income, commodities, currencies, and interest rates. As a writer, his goal is to explain trading and finance concepts in levels of detail that could appeal to a range of audiences, from novice traders to those with more experienced backgrounds.
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Updated
Jun 2, 2024

Geopolitical events can create significant volatility in financial markets, which can impact asset prices, currency values, and overall trading returns. 

To protect against these risks, traders use various hedging strategies. 

This article takes a look at how these hedging strategies can reduce geopolitical risks.

 

Key Takeaways – Geopolitical Risk Hedging Strategies

  • Diversify Portfolios
    • Spread your portfolio across various regions and asset classes to reduce the impact of geopolitical events on any single market.
    • We give an example allocation toward the end of the article. For traders, the portfolio can be traded within the context of that structure.
    • This can help extract risk premiums from the market in a more efficient way by not having to bet on a certain market environment continuing (e.g., mild inflation and quality growth for equities).
  • Use Derivatives
    • Employ options and futures to hedge against potential losses due to political instability or economic sanctions.
  • Stay Informed
    • Regularly monitor geopolitical news and analysis to anticipate and respond to risks, adjusting strategies as necessary.

 

Use of Geopolitical Risk Hedging in Trading

Geopolitical risk hedging is used in trading to:

  • Protect portfolios from sudden market shifts that traders have no control over.
  • Help achieve stable returns during periods of higher geopolitical intensity.
    • We’ve covered in other articles why these episodes may be cyclically increasing.
  • Reduce exposure to adverse market movements caused by geopolitical events.

 

Types of Geopolitical Risks in Financial Markets

Understanding the specific types of geopolitical risks that affect financial markets is important for effective hedging.

These include:

  • Political Instability = Changes in government or political unrest affecting flows and positioning.
  • Economic Sanctions = Trade restrictions impacting the performance of specific industries or markets.
  • Conflict and War = Regional conflicts/wars causing global market disruptions.
  • Regulatory Changes = Sudden changes in financial regulations affecting market operations.

Related: What to Own in a War Economy

 

Hedging Strategies in Financial Trading

Currency Hedging

Currency hedging protects against fluctuations in exchange rates, which geopolitical events can influence.

Forward Contracts

  • Definition – Agreements to buy or sell a currency at a fixed rate on a future date.
  • Use – Locking in exchange rates to avoid adverse movements.

Options

  • Definition – Contracts giving the right, but not the obligation, to buy or sell a currency at a predetermined price.
  • Use – Providing flexibility and protection against unfavorable currency movements while allowing for potential gains.
  • Unique Features – Can be combined in unique ways to create unique exposures. Can be used for shorting, market-neutral, volatility, etc.

Currency Swaps

  • Definition – Agreements to exchange currency amounts at specified dates.
  • Use – Managing long-term exposure to currency fluctuations.

Commodity Hedging

Geopolitical events can cause significant price volatility in commodities.

Hedging strategies include:

Futures Contracts

  • Definition – Contracts to buy or sell a commodity at a predetermined price on a specific date.
  • Use – Locking in prices to protect against market volatility.

Options on Futures

  • Definition – Options to enter into futures contracts.
  • Use – Offering the ability to hedge commodity exposure with more flexibility.

Equity Hedging

Equity markets can be sensitive to geopolitical risks, especially if such risks impact the domestic market.

They can also not impact it much at all if there aren’t major effects on the main two drivers of equity valuations (earnings and interest rates).

Hedging strategies involve:

Index Futures and Options

  • Definition – Contracts based on stock market indices.
  • Use – Hedging against broad market movements influenced by geopolitical events.

Short Selling

  • Definition – Selling borrowed shares with the intent to buy them back at a lower price.
  • Use – Profiting from declining market conditions caused by geopolitical instability.

Fixed-Income Hedging

Geopolitical events can impact interest rates and bond prices.

Strategies include:

Interest Rate Swaps

  • Definition – Agreements to exchange interest rate payments.
  • Use – Managing exposure to fluctuating interest rates.

Bond Futures

  • Definition – Contracts to buy or sell bonds at a future date.
  • Use – Protecting against changes in bond prices due to geopolitical factors.

Volatility Hedging

Volatility often spikes during geopolitical events, affecting all asset classes.

Strategies involve:

VIX Futures and Options

  • Definition – Contracts based on the Volatility Index (VIX).
  • Use – Hedging against increases in market volatility.

Straddles and Strangles

  • Definition – Options strategies that profit from significant price movements in either direction.
  • Use – Protecting against unpredictable market swings.

Scenario Analysis and Stress Testing

Regular scenario analysis and stress testing help traders prepare for potential geopolitical risks:

Risk Assessment

  • Identification – Identifying potential geopolitical events and their market impacts.
  • Analysis – Evaluating how these events could affect trading positions and portfolios.

Simulation Exercises

  • Execution – Conducting market simulations to test trading strategies under various geopolitical scenarios.
  • Evaluation – Looking at the effectiveness of hedging strategies in minimizing losses.
  • Caveats – Depends on the quality of the simulation.

Contingency Planning

  • Development – Creating detailed contingency plans for different geopolitical scenarios.
  • Implementation – How to implement the plan during geopolitical crises.

Below are detailed examples of trades, including exact amounts, to illustrate how these strategies might work.

Currency Hedging: Forward Contracts

Scenario

A US-based company expects to receive €1,000,000 in six months from a European customer.

The company is concerned about potential depreciation of the Euro due to geopolitical tensions.

Trade

  • Forward Contract Amount: €1,000,000
  • Forward Rate: 1.10 USD/EUR (agreed upon with the bank)
  • Action: Enter into a forward contract to sell €1,000,000 at the rate of 1.10 USD/EUR in six months.
  • Outcome: Regardless of market fluctuations, the company will receive $1,100,000 in six months, protecting against Euro depreciation.

 

Commodity Hedging: Futures Contracts

Scenario

An airline company is concerned about rising oil prices due to geopolitical instability in oil-producing regions.

(Rising oil prices eats into margins for airline companies.)

The company uses 500,000 barrels of jet fuel annually.

Trade

  • Futures Contract Amount: 500,000 barrels
  • Current Price: $70 per barrel
  • Action: Buy oil futures contracts for 500,000 barrels at $70 per barrel, to be delivered in one year. This would be 500 contracts of CL for an American firm, given CL has 1,000 barrels of oil per contract. 
  • Outcome: If oil prices rise to $80 per barrel, the company is protected, having locked in the $70 per barrel price. The financial impact of increased fuel costs is mitigated.

 

Equity Hedging: Index Options

Scenario

A trader holds a portfolio of US stocks worth $1,000,000 and is concerned about potential market downturns due to escalating geopolitical tensions.

Trade

  • Index: S&P 500
  • Current Level: 5,000
  • Put Options Strike Price: 4,800
  • Number of Contracts: 10 (each contract covers 100 shares, total 1,000 shares)
  • Premium: $30 per contract
  • Action: Buy 10 put option contracts on the S&P 500 with a strike price of 4,800, expiring in three months.
  • Outcome: If the market drops below 4,800, the puts increase in value, offsetting losses in the stock portfolio. The maximum cost of this hedge is $30,000 (premium paid).

 

Fixed-Income Hedging: Interest Rate Swaps

Scenario

A company has a $10,000,000 loan with a floating interest rate tied to SOFR.

Geopolitical events can cause interest rates to spike in certain scenarios (e.g., commodity prices rise, leading to inflation and higher equilibrium interest rates), increasing the company’s interest expenses.

Trade

  • Loan Amount: $10,000,000
  • Current SOFR Rate: 5%
  • Swap Agreement: Convert floating rate to a fixed rate of 6% for five years.
  • Action: Enter into an interest rate swap agreement to pay a fixed rate of 6% and receive SOFR.
  • Outcome: The company’s interest payments are fixed at 6%. This protects against rising SOFR rates due to geopolitical instability.

 

Volatility Hedging: VIX Options

Scenario

A trader anticipates increased market volatility due to an impending geopolitical event, such as a major election or conflict.

Trade

  • Current VIX Level: 20
  • Call Options Strike Price: 25
  • Number of Contracts: 50 (each contract covers 100 shares)
  • Premium: $2 per contract
  • Action: Buy 50 VIX call option contracts with a strike price of 25, expiring in two months.

Outcome: If volatility spikes and the VIX rises above 25, the call options increase in value. The total cost of this hedge is $10,000 (premium paid).

 

Diversification Strategy Explanation

Diversifying your portfolio means spreading your exposures across different regions and asset classes, such as stocks, bonds, commodities, currencies, and even private assets.

Diversification is also free in the sense that you aren’t taking negative-expected value bets just to protect against losses in the core parts of the portfolio.

This approach reduces the risk associated with geopolitical events impacting a single market or region.

For instance, if a political crisis negatively affects the stock market in one country, exposures in other regions or asset classes can help offset those losses.

By not putting all your eggs in one basket, you can better manage and reduce the potential negative effects of geopolitical risks on your overall portfolio.

Here’s an example of a diversified portfolio allocation:

Example Diversified Portfolio Allocation

Regions

North America: 50%

  • US: 45%
  • Canada: 5%

Europe: 20%

  • Non-UK Europe: 15%
  • UK: 5%

Asia: 15%

  • Japan: 5%
  • Emerging Asian Markets: 10%

Other Regions: 15%

  • Latin America: 5%
  • Africa and Middle East: 5%
  • Australia: 5%

Currencies

  1. US Dollar (USD): 45%
  2. Euro (EUR): 15%
  3. Japanese Yen (JPY): 5%
  4. Other Currencies (CAD, GBP, etc.): 35%

Asset Classes

Equities: 35%

  • Large Cap: 25%
  • Mid Cap: 5%
  • Small Cap: 5%

Bonds: 45%

Commodities: 20%

Nominal and Inflation-Linked Bonds

Nominal Bonds: 15%

  • US Treasuries: 10%
  • European Government Bonds: 5%

Inflation-Linked Bonds: 15%

  • US TIPS (Treasury Inflation-Protected Securities): 10%
  • Other Inflation-Linked Bonds: 5%

This diversified allocation helps reduce the risks associated with geopolitical events by spreading exposures across various regions, currencies, and asset classes.

It also includes a balance between nominal and inflation-linked bonds to protect against different types of economic unknowns.

Related: Balanced Beta