Managing Political Risk in International Portfolios

Abstract

We show that internationally diversified portfolios carry sizeable political risk premia. Using a portfolio selection model with tail risk, we obtain political efficient frontiers from skewed return distributions to manage political risk, and design an inference test to draw conclusions. We find that politically hedged international portfolios of US investors realize performance gains against a broad market index (and other benchmarks). Currency hedging does not eliminate political risk. The diversification gains increase for long-horizon investors. Qualitatively identical results are obtained for Eurozone and Japan. Our findings inform the home equity bias puzzle literature, and are robust to several model specifications.