Geopolitical risk and BTP yields: A long-run cointegration analysis

This study investigates the long-run relationship between geopolitical risk (GPR) and Italian sovereign bond yields over the period 1994 – 2024, with the aim of reassessing the determinants of the risk-free component of the cost of capital. While standard financial theory typically assumes the risk-free rate to be exogenous and stable, increasing evidence suggests that geopolitical uncertainty may systematically influence sovereign yield dynamics. To address this issue, the empirical analysis was settled on Johansen cointegration model within a vector error correction framework, enabling the identification of both long-run equilibrium relationships and short-run adjustment mechanisms. Using annual data that combine a country-specific measure of GPR with yields on Italian government bonds, the results provide evidence of a stable long-run equilibrium linking the two variables. Notably, the estimated relationship is negative, indicating that higher levels of geopolitical risk are associated with lower sovereign yields over the long term. The short-run dynamics show that deviations from equilibrium are primarily corrected through adjustments in bond yields, while geopolitical risk exhibits limited responsiveness. These findings suggest that the interaction between geopolitical uncertainty and sovereign bond markets is more complex than commonly assumed. In particular, periods of heightened geopolitical tension may coincide with capital inflows or policy interventions that contribute to yield compression, with implications for asset pricing and cost-of-capital estimation.