Political Risk Assessment - Big exposures are often under evaluated

Macro investing will focus on global monetary policy and growth and make assessments on relative asset returns, yet there does not always seem to be a structured approach to political risks. A structured approach looks at different types of political risk and then tries to understand the core questions for these risks, analyze the likelihood of these risks, form an action plan of taking exposure or mitigation, and then responding with trades. 

These issues are addressed in the book Political Risk: How Businesses and Organizations Can Anticipate Global Insecurity by Condoleezza Rice and Amy Zegart. While this is a book focused on corporate political risk assessment, it is very relevant for any fund manager. 

The book focuses on a set of political risks and when I review the list, it becomes immediately obvious that it is applicable to any market assessment.  Some of these risks are firm specific and not asset class focused, but it still has clear relevance for macro investing.

The problem with any political risk assessment is that many of these risks have low likelihood of occurring, so it is not easy to price and take advantage of opportunities. Most political risks have the chance of being large tail events given they are hard to price; consequently, it is all the more important to analyze and assess. 

Rice and Zegart focus on a four step process: understand, analyze, mitigate and respond. Understanding political risk starts with assessing a firm's political risk appetite. For example, an investment in Mexican equities or bond is a relative return analysis based on political risk assessment. If you cannot or do not have the skill to take on political risk, then it should be avoided regardless of the potential return. The analysis starts with the information that is available. Is there good information on the risks that can be used for rigorous analysis. Risk mitigation is a function of having a warning system that can alert you of higher risks. The warning system will allow risks to be mitigated and damage limited. Finally, effective risk management will assess responses to threats. Good response determines whether risks were avoided, and opportunities capitalized.

If you are a macro investor, a structured assessment of political risks is essential for good portfolio construction. There is no positive gain from diversification if there are just hidden political risks unassessed.