Geopolitical Risk and Trading Patterns of Foreign and Domestic Investors: Evidence from Korea

We examine how geopolitical risk affects investors' investment strategies in the Korean market. The information advantage hypothesis predicts that foreign investors become more reluctant to invest in the portfolios of foreign countries due to increased information asymmetry following geopolitical risk escalation while the international diversification hypothesis predicts that foreign investors will not reduce the size of their foreign portfolios because their wealth portfolios are sufficiently diversified. Using a novel measure of geopolitical risk, we find evidence consistent with the information advantage hypothesis: when North Korea risk is highly escalated, foreign investors reduce while domestic investors increase the value of their Korean portfolios, and domestic institutional investors significantly outperform foreign investors due to increased information asymmetry.