Managing Geopolitical Risk In Investment Decision Making Sixth Global Fixed Income Capital Markets/Investment Management Workshop/Retreat July 20-24, 2002 Aspen, Colorado Managing Geopolitical Risk In Investment Decision Making Campbell R. Harvey Duke University and National Bureau of Economic Research

Unfortunately, this case is on the program because of September 11. The Risk Setting Unfortunately, this case is on the program because of September 11. Risk management advances have been focused largely on market risks, i.e. VaR models Now, there is significant interests in managing GPR

The Risk Setting Big picture issues Is GPR “diversifiable” or “systematic”? Uncertainty versus risk? How does GPR fit into an investment management strategy?

The Risk Setting Some reading: Campbell R. Harvey, 1994, “National Risk and Global Fixed Income Allocation,” with C. Erb and T.E. Viskanta, Journal of Fixed Income. Campbell R. Harvey, 1996, “Political Risk, Financial Risk and Economic Risk,” with C. Erb and T.E. Viskanta, Financial Analysts Journal. Campbell R. Harvey, 1996, “The Influence of Political, Economic and Financial Risk on Expected Fixed Income Returns,” with C. Erb and T.E. Viskanta, Journal of Fixed Income. Campbell R. Harvey, 2000, “The Drivers of Expected Returns in International Markets,” Emerging Markets Quarterly.

The U.S. has become much more risky The Risk Setting The U.S. has become much more risky High sensitivity to some GPRs Disagreement on strength of economy Financial information less credible

U.S. Has Become a Riskier Global Investment ICRG Political Risk

U.S. Has Become a Riskier Global Investment ICRG Political Risk

U.S. Has Become a Riskier Global Investment Risk Ratings August 2002

U.S. Has Become a Riskier Global Investment Risk Ratings May 2001

U.S. Has Become a Riskier Global Investment Higher risk means equity investors require a higher rate of return

U.S. Has Become a Riskier Global Investment Regression equation implies an increase in the medium-term risk premium of 240bp This helps explain the recent decline in the equity market This helps explain the recent behavior of the U.S. dollar This helps explain the slow down in real investment (hurdle rates are up)

Diamond Asset Management Company Previous CIO “fallen on the sword” because of failure to have detailed contingency plans for GP events – like September 11 Diamond characterized as “geopolitical planning void”

Diamond Asset Management Company First attempt to develop a strategy

U.S. Has Become a Riskier Global Investment