Hedging political risk in international portfolios

We show that internationally diversified portfolios carry sizeable political risk premia and expose investors to tail risk. We obtain political efficient frontiers with and without hedging political risk using a portfolio selection model for skewed distributions and develop a new asymptotic inference test to compare portfolio performance. Politically hedged portfolios outperform a broad market index and the equally weighted portfolio for US, Eurozone, and Japanese investors. Political risk hedging is not subsumed by currency hedging, and the diversification gains of politically hedged portfolios persist under currency hedging and transaction cost frictions. Hedging political risk induces equity home bias but does not fully explain the puzzle. • International portfolios with zero covariation with a global political risk P-factor. • Portfolio selection for skewed returns optimizing mean-to-CVaR performance ratio. • Asymptotically valid inference test for mean-to-CVaR ratios. • Diversification gains persist when political risk and currency risks are hedged. • Political risk hedging induces but does not explain the equity home bias puzzle.