We examine how firms navigate risks in geopolitical tension through diversification strategies. Drawing on real options theory, diversification enhances flexibility by providing more options but also increases risk exposure, making it essential to evaluate which options are beneficial and which may heighten risks. We argue that facing geopolitical risks, product diversification provides flexibility and lower sunk costs, whereas international diversification increases exposure to geopolitical risks and long-term commitments. Based on a sample of U.S. sanctions on relevant industries of Chinese firms from 2013 to 2022, the results of our difference-in-differences analyses reveal that institutional risks arising from U.S. sanctions drive Chinese firms to increase their inclination toward product diversification while reducing international diversification. Additionally, engaging in Environmental, Social, and Governance (ESG) activities and leveraging access to political resources as critical non-market capabilities can help firms better manage the geopolitical risks, thereby further promoting product diversification and reducing the negative impact on international diversification. This study underscores the role of geopolitical risks and non-market capabilities in shaping different diversification decisions, providing valuable insights into how firms manage uncertainty in volatile environments.
