Geopolitics: Tools, Risks, and Investments | CFA Level I Economics

In this lesson, we’ll dive deeper into geopolitics, focusing on the types of geopolitical tools and how to analyze geopolitical risks.

Types of Geopolitical Tools

Geopolitical tools are the means by which state actors advance their interests in the world. They can be classified as:

• National security tools
• Economic tools
• Financial tools

These tools can be used to facilitate cooperation or escalate conflict, and they may advance globalization or nationalism.

National Security Tools

• Armed conflict, espionage, and terrorism are examples of national security tools.
• These tools are generally non-cooperative and advance nationalism.
• Military alliances, like NATO, can advance cooperation but may also create divisions between members and non-members.

Economic Tools

• Examples include multilateral trade agreements (e.g., WTO) and common markets (e.g., European Union).
• Non-cooperative economic tools include nationalization, tariffs, quotas, and voluntary export restraints.
• Domestic content requirements can also be considered nationalistic economic tools.

Financial Tools

• Cooperative financial tools include free exchange of currencies and allowing foreign investment.
• Restrictions on currency exchange and foreign investment are non-cooperative financial tools.
• Sanctions can also be used as financial tools to create conflicts.

Analyzing Geopolitical Risks

There are three main types of geopolitical risks:

1. Event risks – Known events with uncertain outcomes (e.g., national elections).
2. Exogenous risks – Unanticipated events (e.g., wars, natural disasters).
3. Thematic risks – Long-term factors (e.g., climate change, cyber threats).

Geopolitical risks can affect investment values by increasing or decreasing the risk premium investors require to hold assets in a country or region. As an investor or portfolio manager, you should assess:

1. Likelihood of the risk
2. Velocity (pace) of the risk
3. Size and nature of the impact

Using a cooperation and globalization framework can help estimate the likelihood of geopolitical risks. Signposts or data points can signal when the likelihood of an event is increasing or decreasing, such as volatility indicators in financial markets.

Velocity can be classified as high, medium, or low, depending on the pace at which the geopolitical risk affects the investment portfolio.

The size and type of impact can vary greatly, so investors should focus on high-impact risks and use qualitative or quantitative scenario analysis to gauge potential effects.

Investor’s Course of Action

An investor’s objectives, risk tolerance, and time horizon will determine the importance of geopolitical risk in their investment process. Some possible actions include:

• Reducing exposure to geopolitical risk through low-volatility investment choices or hedging for investors with low risk tolerance.
• For investors with a long time horizon, high-velocity geopolitical events like exogenous shocks can present buying opportunities.
• Investors nearing retirement, with shorter time horizons, might want to overweight safe-haven assets in the face of heightened geopolitical threats.

In conclusion, the reality of geopolitics is much more complex than presented in the CFA curriculum. However, with some common sense and the information provided here, you should be well-equipped to handle any related exam questions.