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CFA Level I · CFA Level I Exam · Introduction to Geopolitics

When assessing the impact of a geopolitical risk on an investment portfolio, which approach is most appropriate for an analyst facing a risk with a low probability but potentially severe consequences?

Scenario analysis is most appropriate. It lets the analyst estimate portfolio outcomes if a rare but severe event occurs, where historical data are scarce. Ignoring low-probability risks or relying on historical averages would understate the potential impact of the event.

  1. AIgnore the risk because its probability is low
  2. BUse scenario analysis to estimate portfolio outcomes under the eventCorrect
  3. CRely only on historical average returns to set expectations

Explanation

Scenario analysis allows analysts to examine how a portfolio would behave if a rare, severe event occurred, since historical data are limited. Ignoring the risk disregards its large potential impact, and historical averages do not capture such events.

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