CFA Level I · CFA Level I Exam · Introduction to Geopolitics
An investment analyst is assessing how geopolitical risk could affect a portfolio. Which of the following is the most appropriate way to treat a geopolitical event that has a low probability but a very large potential impact?
Scenario analysis is the most appropriate treatment. It lets the analyst estimate how a portfolio would fare if the low-probability, high-impact event occurred, without ignoring the tail risk or acting as though the event were certain, which would be an overreaction.
- AIgnore it, because low-probability events cannot affect valuations
- BAssess it through scenario analysis that estimates the portfolio effectCorrect
- CAssume it will occur and liquidate all risk assets immediately
Explanation
Low-probability, high-impact events are best handled with scenario analysis, which estimates potential effects without assuming the event occurs. Ignoring the event overlooks tail risk, and liquidating everything treats a possibility as a certainty.
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