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Does geopolitical risk affect firms' idiosyncratic volatility? Evidence from China

Journal: International Review of Financial Analysis

Date: 2023

Author: Xiaohang Ren, Yuxuan Cao, Pei Liu, Dun Han

Abstract:
Using 2663 Chinese A-share listed companies from 2003 to 2019, we investigate the relationship between geopolitical risk (GPR) and firm idiosyncratic volatility through panel fixed effects and attempt to explain the mechanism. The main findings are presented as follows. First, GPR can explain the change of firms' idiosyncratic volatility. Different industry conditions and ownerships have heterogeneous effects on the firms' idiosyncratic volatilities. In addition, the interaction terms of ownership concentration, competitive intensity and operating leverage with GPR are statistically significant, and they interact with GPR to affect firms' idiosyncratic volatility. After we conduct a series of robustness tests using methods such as instrumental variables, we innovatively introduce the South China Sea dispute as an external event and use the DID (Difference-in-difference) model to analyze the impact of geopolitical events on corporate risk-taking, our findings remain valid. Our research contributes to a better understanding of geopolitical risk and firms' idiosyncratic volatility.

Link: Google Scholar

Background and Context

Research Focus

This study examines how geopolitical risk affects the idiosyncratic volatility (firm-specific risk) of Chinese companies using data from 2,663 Chinese A-share listed companies from 2003-2019.

Methodology

The research uses panel fixed effects regression analysis and a difference-in-differences model focusing on the 2012 South China Sea dispute as an external shock event.

Data Sources

The study utilizes the Chinese Geopolitical Risk (GPR) index, financial data from CSMAR database, and controls for various firm characteristics like size, leverage, and ownership structure.

Negative Impact of Geopolitical Risk on Firm Risk-Taking

Shows the negative relationship between geopolitical risk (GPR) and firm idiosyncratic volatility
A one-unit increase in GPR leads to a 0.092 unit decrease in firm risk-taking
Market leverage has a positive effect while firm size and profitability measures show negative effects

Different Effects Based on Market Conditions

Illustrates how market conditions influence the relationship between GPR and risk-taking
Firms increase risk-taking under favorable conditions (positive coefficient)
Risk-taking decreases under unfavorable conditions (negative coefficient)

Ownership Type Impact on GPR Response

Demonstrates how ownership structure affects firms' response to geopolitical risk
State-owned enterprises show stronger negative response to GPR
Both types of ownership show risk reduction but with different magnitudes

GPR Index Trend During Study Period

Shows the evolution of geopolitical risk in China from 2003 to 2019
Notable spike in GPR after 2015, particularly during 2016-2018 period
Corresponds with increased international tensions and the South China Sea dispute

South China Sea Dispute Impact (DID Analysis)

Illustrates the impact of the 2012 South China Sea dispute on firm risk-taking
Shows a significant change in risk-taking behavior after the dispute
Demonstrates how specific geopolitical events can affect corporate behavior

Contribution and Implications

Provides new insights into how geopolitical risks affect firm-level decision-making in emerging markets
Demonstrates the importance of considering ownership structure and market conditions in risk management
Offers practical implications for corporate risk governance under geopolitical uncertainty

Data Sources

Baseline results chart: Constructed using data from Table 4, columns (8)
Market conditions chart: Based on Table 5 regression results
Ownership impact chart: Derived from Table 6 coefficients
GPR trend chart: Created using data from Figure 1
DID analysis chart: Based on Table 9 results