Level 1 CFA® Exam:
Geopolitics in Investment
Geopolitical risk – risk related to tensions between state or non-state actors and their actions that can negatively impact normal peaceful relations. This kind of risk usually occurs when geographic or political factors change after some time of stability, e.g., due to a shift in policy, natural disaster, war, etc.
There are 3 types of geopolitical risks:
- event risk is associated with specific dates and events, e.g., Brexit (around that date investors’ expectations as regards the level of international cooperation changed)
- exogenous risk is unanticipated and sudden and affects the ability of state actors to cooperate and/or the ability of non-state actors to globalize, e.g., invasions, natural disasters
- thematic risk is known and it evolves over time, e.g., climate change, cyber threats.
Markets tend to react to different geopolitical threats, as well as actual events that occur as a result of these threats such as an election victory that leads to a political change, military attack, uprising, data breach, etc.
Countries with lower exposure to geopolitical risk are able to attract more resources (such as labor or capital). In turn, areas with a threat of conflict are characterized by regular volatility in asset prices, which makes investors require higher compensation for the risk taken.
There are 3 aspects of geopolitical risk that investors should consider when making an assessment:
- LIKELIHOOD: How likely is the risk to occur?
- VELOCITY: How quick will its impact be?
- IMPACT: How big and important will this impact be?
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Geopolitical risks are not linear and thus are hard to predict. Scenario building and signposting are the right tools to cope with geopolitical risks rather than single-point forecasts.
Scenario analysis – quantitative and/or qualitative analysis of portfolio outcome depending on different circumstances and states of the world
Scenario analysis should be based on answers to questions such as: What is the most impactful outcome of the risk? How likely is the risk to occur? Will it have short-term or long-term consequences? What will market recovery possibly look like?, etc.
Good scenario analysis requires both time and resources for good decisions to be made. It helps to build a portfolio’s resilience to unexpected change. Groupthink is a dangerous phenomenon of making investment-related decisions as a group, which dismisses responsibility and creativity. Reliable scenario analysis needs creative and responsible processes that allow scenario identification, assessment, and application if necessary.
One of the most important processes is the identification of signposts for priority risks.
Signpost – any piece of financial data or an event that signals whether a risk is getting more or less likely; the right signposts are usually identified by trial and error
It is important that the analyst can distinguish signal from noise. Signals can be given “traffic lights” labels:
GREEN >> signal suggests low/decreased likelihood, velocity, impact >> no action required
AMBER >> signal suggests medium likelihood, velocity, impact >> caution recommended
RED >> signal suggests high/increased likelihood, velocity, impact >> action plan may be required
Analysts should constantly check if scenarios assumed in their analysis materialize or not and whether any action is needed.
Geopolitical Risk Index (GPR) is a consistent measure of real-time geopolitical risk over time as perceived by the press, the public, global investors, and policymakers. It was first introduced in 2019 in a study that analyzed articles reporting geopolitical tensions and their impact on economic events.
3 main observations of the 2019 GPR study:
- US investment, employment, and stock market prices decreased when geopolitical risks were high.
- Individual companies invested less if the industry they operated in was directly exposed to geopolitical risks.
- Geopolitical events have an adverse effect and the threat of such events has an even bigger impact than the events themselves as time passes.
Geopolitics is important for finance because relations between countries affect economic growth, business performance, market volatility, and transaction costs. These economic factors are key to investment performance.
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- Geopolitical risk is related to tensions between state or non-state actors and their actions that can negatively impact normal, peaceful relations. This kind of risk usually occurs when geographic or political factors change after some time of stability, e.g., due to a shift in policy, natural disaster, war, etc.
- There are 3 types of geopolitical risks such as event risk, exogenous risk, and thematic risk.
- The 3 aspects of geopolitical risk that investors should consider when making an assessment are LIKELIHOOD, VELOCITY, and IMPACT.
- Scenario analysis is the quantitative and/or qualitative analysis of portfolio outcome depending on different circumstances and states of the world.
- Signpost is any piece of financial data or an event that signals whether a risk is getting more or less likely. The right signposts are usually identified by trial and error.
- Geopolitical Risk Index (GPR) is a consistent measure of real-time geopolitical risk over time as perceived by the press, the public, global investors, and policymakers. It was first introduced in 2019 in a study that analyzed articles reporting geopolitical tensions and their impact on economic events.