Impact of Geopolitical Risk on Investment

The degree to which investors take geopolitical risk into account when making decisions will greatly depend on their investment goals and risk appetite. While geopolitical risk may be welcomed by certain investors while it may also be shunned by others in their decision-making process.

Three types of geopolitical risk include:

i. Event Risk

This is based on predetermined dates, such as elections, the enactment of new laws, or other date-based events, such as festivals or political anniversaries. Investor expectations frequently shift as a result of political events. Political timelines are a common starting point for risk analysts when evaluating event risk.

ii. Exogenous Risk

Exogenous risk is an abrupt or unplanned concern that affects a nation’s willingness to cooperate and non-state actors’ capacity to go internationally. Unexpected revolutions, invasions, or the aftermath of natural calamities are a few examples.

iii. Thematic Risk

Thematic risk is a risk that concerns are well-known, and they change and grow with time. Examples include the persistent danger of terrorism, climate change, migratory patterns, the emergence of populist movements, and cyber threats.

Geopolitical Risk in a Financial Environment

In the financial environment, geopolitical risk is constantly present and has various effects on assets. An investor evaluates geopolitical risk within the following three categories:

i. Likelihood It will Occur

The likelihood of the occurrence of risk is the possibility that it will materialize. The procedure of measuring probability is, however, difficult.

More collaborative and globalized nations are generally less likely to incur geopolitical risk due to the increased political, economic, and financial costs associated.   Additionally, internal political stability, economic need, and governmental actors’ incentives all contribute significantly to the likelihood of disruptive action.

ii. Velocity (Speed) of its Impact

This is the rate at which geopolitical risk affects an investor’s portfolio.

Volatility may, in the short term, have an impact on the entire market. Exogenous or “black swan” events are likely to fall under this classification. An unusual, unpredictable incident that has a significant impact is known as a “black swan risk,”. An example of such an incident is a world war.

Risks that have a medium-term impact may start to affect business operations, expenses, and investment prospects, resulting in reduced valuations. They often target particular industries and affect some businesses more than others.

Long-term risks might significantly affect the environment, society, government, and other areas. The immediate effect on portfolios is likely to be less significant. Noting that various risks affect investments in more than one way is important.

3. Size and Nature of that Impact

The effects of risk on investor portfolios might take many different forms. When evaluating the significance of a risk to the investing process, investors should consider the magnitude of the risk’s impact. While a low-impact risk would not require as much analysis of its reasons and drives, a high-impact risk call for attention.

The nature of the impact might be discrete or broad. A discrete impact is one that only affects one business or industry at a time. A broad impact, on the other hand, affects an entire industry, a nation, or the whole global economy.

Investors should consider all three geopolitical risk factors—likelihood, velocity, size, and nature of impact—when evaluating geopolitical risk for portfolio management. For instance, a risk that is extremely probable but has minimal effect on a portfolio may not warrant in-depth research and investor attention.

Scenario Analysis

This is the technique of analyzing portfolio performance across various situations or global states.  A team’s commitment to its priorities and reaction can be strengthened through scenario analysis. Scenario analysis might be a qualitative analysis, quantitative measurement, or a combination of the two.

Creating a base case for an event is the first step in qualitative scenario development. Investors can then think about both positive and negative possibilities from there to create best-case and worst-case scenarios.

The complexity of quantitative scenarios might vary greatly. A stylized scenario is a type of simple quantitative scenario in which  a portfolio’s sensitivity is evaluated in relation to one important aspect that is significant to it. Such an aspect could be interest rates, asset prices, or exchange rates.

Scenario construction is a great technique for tracking risks and determining the portfolio measures that may be worthwhile since it can encourage investors to change their risk prioritizing.

Asset managers create procedures that provide quick corrections in order to strengthen a portfolio’s resistance to unforeseen change. The process of detecting warning signs for proper risk management is crucial.

A signpost is an indicator, a piece of data, or an event suggesting that risk increases or decreases in likelihood. The ability to recognize signposts should enable a team to distinguish between signal and noise and respond when signposts indicate increased risk. It might be difficult to find the correct signposts without some trial and error. Certain combinations of economic and financial market conditions can act as clear indicators of impending trouble. Political turmoil, for instance, may be indicated by elevated inflation and declining employment.

Acting on Geopolitical Risk

Assessing a risk’s likelihood, velocity, and impact might assist an investor in isolating the risks that may be the most significant.

Asset allocators may use a top-down approach and incorporate geopolitical risk in their asset allocation plans. Risks’ likelihood, velocity, and impact may impact key capital market assumptions.

Investors might consider geopolitical risk in multi-factor models at the portfolio management level.

Investing objectives, risk tolerance, and time horizon all affect how important geopolitical risk is to the process of combating geopolitical risk. Reducing exposure to geopolitical risk may be acceptable for an investor with limited risk tolerance. Even then,  for an investor with a long-time horizon, a geopolitical event, like an unpredictable event, may present a purchasing opportunity.

Question

Which of the following geopolitical risk is most likely a known risk that evolves and expands over a period of time?

1. Event risk.
2. Thematic risk.
3. Exogenous risk.

The correct answer is B.

Thematic risk is a type of geopolitical risk that is known, evolves, and expands over a period of time. Examples include climate change and ongoing threats of terrorism.

A is incorrect. Event risk is a type of geopolitical risk that revolves around set dates or date-driven milestones such as elections or political anniversaries.

C is incorrect. Exogenous risk is a type of geopolitical risk. It is a sudden or unanticipated risk that impacts a country’s cooperative stance or the ability of non-state actors to globalize. Examples include invasions and sudden uprisings.