Geopolitical risk and the aerospace & defense sector: implications for risk management and portfolio optimization

Amidst intensifying geopolitical instability, this study delves into the complex network of relationships between the aerospace & defense sector and a cluster of relevant markets, including core financial instruments (equity, industrials, global equity, treasury bonds, U.S. Dollar Index), key commodities (crude oil, gold, copper, aluminum), and pivotal global risk indices (VIX, Geopolitical Risk Index). Using the R2 decomposed connectedness approach and drawing upon a comprehensive dataset that spans from 1 January 2010, to 28 February 2025, we analyze the evolving patterns of interdependencies. The findings reveal a marked temporal heterogeneity and pronounced surges in dynamic connectedness during major global events, demonstrating the aerospace & defense sector’s susceptibility to systemic risks. Furthermore, we find that while aerospace & defense is a robust hedge for equities, its bivariate effectiveness is limited across other assets. Nevertheless, multivariate hedging strategies yield enhanced risk-reduction, outperforming bivariate constructs. Beyond direct hedging, aerospace & defense emerges as a powerful diversifier, with its integration into multivariate portfolios providing even greater risk-mitigation gains and superior risk-adjusted returns. These outcomes furnish valuable insights for investors and policymakers, underscoring the imperative of robust risk management techniques and the potential of aerospace & defense to refine the risk-return attributes of investment portfolios.