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How We Think About Negotiating Power

By: William Blair
Harvest Exchange
March 2, 2018

How We Think About Negotiating Power

Geopolitical forces work outside of fundamental valuation but these forces have become increasingly influential in moving market and currency prices around fundamental value in the short- to medium-term. We use game theory as a framework by which to evaluate these influences and ultimately navigate these geopolitical forces.

Regardless of how sound our fundamental analysis is, we cannot possibly predict every geopolitical influence that might work against it. And that is a relatively new development.

During the Cold War, mutually assured destruction (MAD) was often frightening to live through, but it created a mostly stable investing environment. Since the Cold War’s demise, we no longer operate in that same environment—the world has become increasingly unstable. This instability greatly increases the chance that geopolitical forces will influence markets and currencies.

Longer-term investors (10+ years), can largely ignore these influences and simply align portfolios directly with fundamentals. But our business doesn’t work like that—we are accountable to our investors on a daily basis. Thus, we must successfully navigate these often powerful geopolitical influences.

The world has become very geopolitically unstable. This instability greatly increases the chance that geopolitical forces will influence markets and currencies.

As a team, we have long thought about geopolitical influences in terms of negotiating powers and how they might influence near-term price movements. But we eventually realized that a formal analytical framework was necessary to best and most consistently do this and that is when we introduced game theory as a key component of our investment process.

We have evolved the game theory framework even more over the past few years. That is because some of the powers and influences within the framework had become correlated. As a result, we concluded that the framework and means of analysis wasn’t providing independent information. So, we consolidated some of the powers and developed a new measure of the power that a country or a leader might have in a game theater—net influence.

Salience is another aspect of this framework that was developed over time. Salience refers to how important a particular negotiation might be to a player.

This is important because a player within the game theater may have a lot of power through the formation of coalitions or from the endowment of weapons or capital, for example, but if this player has little interest in the outcome, the player’s overall power is diminished.

Conversely, a player with little negotiating influence but who cares deeply about the resolution may go to much greater lengths in order to achieve an objective, which may result in greater overall net influence than would otherwise be the case.

To illustrate, consider our Europe-Russian Game Theater.

Russia has expressed a high tolerance for risk at this point, in part through its infringement of the sovereignty of Ukraine and involvement in Syria. Meanwhile, the United States is generally reluctant to engage in direct conflict with Russia, and its passivity puts the burden on Europe to solve its energy, migration, and military programs with Russia.

The development of this situation has potential implications for Russian and European assets and currencies. Geopolitical gains for Russia can benefit the nation (unless they lead to retaliations via military force, sanctions, or political exclusion), and European strength in these disputes could lead to decreased demand for Russian energy supplies and, thus, lower energy prices, for example.

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Originally Published at: How We Think About Negotiating Power