(North Korean leader Kim Jong Un in a photo released by North Korea's Korean Central News Agency (KCNA) on April 19, 2015KCNA/Reuters)
North Korea isn't a country investors usually look at, but it has been on people's minds amid rising geopolitical risk.
And so, it's interesting to consider how markets assess the risk of a country like North Korea without either hysterically overreacting in the short-term or waving the risk off completely, especially given that any turbulence could have a spillover effect into both emerging and developed markets such as China and South Korea.
Generally speaking, analysts can build models for "known" risks by creating a statistical model based on earlier episodes. For example, the effect of a possible rate hike by the Federal Reserve on the markets can be analyzed by looking at the history of Fed rate decisions, and what happened after interest rates were hiked in the past. Of course, this is not an exact science, and things can happen differently than they did in the past, so there will be some variation and unexpected outcomes.
However, when it comes to a country like North Korea — especially now that it has nuclear weapons — investors have to try to model and predict the likelihood and effects of a shock event, like a full-blown military conflict, that has not happened in the recent past. Worse, we have no idea how things might play out given numerous other unknown and unpredictable variables such as US foreign policy. Plus, since the Hermit Kingdom is effectively an autarky and is not directly connected to global markets, investors would have to try to predict how reverberations will play out across other markets such as China, South Korea, or the US.
And so, to get a sense of how markets consider the Hermit Kingdom risk, Business Insider spoke with two bankers at a breakfast meeting hosted by UBS on Thursday about their views of the current North Korea situation specifically, and more broadly, how they think about countries that have seen breakdowns in institutions.
"Asia trades as if North Korea wasn't a problem," Federico Kaune, the head of emerging markets fixed income at UBS Asset Management, told Business Insider. "Quite frankly, I don't think markets are pricing in fully — or not even to some extent — the North Korean risks."
"I think that's something we are all aware of. And if something happens, obviously the markets are going to have a pretty bad reaction because there is no compensation for that specific uncertainty," he added. "When it comes to the shocks, I mean, it’s pretty difficult to actually come up with a view of what might happen in these countries."