Does geopolitical risks predict stock returns and volatility of leading defense companies? Evidence from a nonparametric approach

Abstract

We use the k-th order nonparametric causality test at monthly frequency over the period of 1985:1 to 2016:06 to analyze whether geopolitical risks can predict movements in stock returns and volatility of twenty-four global defense firms. The nonparametric approach controls for the existing misspecification of a linear framework of causality, and hence, the mild evidence of causality obtained under the standard Granger tests cannot be relied upon. When we apply the nonparametric test, we find that there is no evidence of predictability of stock returns of these defense companies emanating from the geopolitical risk measure. However, the geopolitical risk index does predict realized volatility in 50 percent of the companies. Our results indicate that while global geopolitical events over a period of time is less likely to predict returns, such global risks are more inclined in affecting future risk profile of defense firms.