IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Login to save this paper or follow this series

Option Pricing and Foreign Investment under Political Risk

  • Cherian, Joseph A
  • Perotti, Enrico C

The paper analyzes foreign investment and asset prices in a context of uncertainty over future government policy. The model endogenizes the process of learning by foreign investors facing a potentially opportunistic government, which chooses strategically the timing of a policy reversal in order to attract more capital. We characterize the evolution of confidence, investment, and asset prices over time, as well as perceived policy risk. Quite generally, perceived risk abates as current policy is maintained, leading to a gradual appreciation of asset prices and a gradual decrease in their conditional variance. The approach thus provides a measure of the evolution over time of perceived political risk from market prices. We next compute option prices under the process generated by the model's hazard rate of policy reversal plus an additional market risk component. We show that both the time series and the term structure of conditional volatility in general is downward sloping and its overall level falls steadily over time, although it may exhibit initially a hump shape in the case of very low initial reputation. Another testable implication is that in price series without a policy reversal, implied volatility from option prices will exceed actual volatility. Over time, and in the absence of a reversal, this wedge progressively disappears. This may be viewed as the volatility analogue of the 'peso premium' for assets subject to large, infrequent price drops.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://www.cepr.org/active/publications/discussion_papers/dp.php?dpno=2327
Download Restriction: CEPR Discussion Papers are free to download for our researchers, subscribers and members. If you fall into one of these categories but have trouble downloading our papers, please contact us at subscribers@cepr.org

As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2327.

as
in new window

Length:
Date of creation: Dec 1999
Date of revision:
Handle: RePEc:cpr:ceprdp:2327
Contact details of provider: Postal: Centre for Economic Policy Research, 77 Bastwick Street, London EC1V 3PZ.
Phone: 44 - 20 - 7183 8801
Fax: 44 - 20 - 7183 8820

Order Information: Email:


References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Thomas, Jonathan & Worrall, Tim, 1990. "Foreign direct investment and the risk of expropriation," Kiel Working Papers 411, Kiel Institute for the World Economy.
  2. Eaton, Jonathan & Gersovitz, Mark & Stiglitz, Joseph E., 1986. "The pure theory of country risk," European Economic Review, Elsevier, vol. 30(3), pages 481-513, June.
    • Jonathan Eaton & Mark Gersovitz & Joseph E. Stiglitz, 1991. "The Pure Theory of Country Risk," NBER Chapters, in: International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics, pages 391-435 National Bureau of Economic Research, Inc.
  3. Chamley, Christophe & Gale, Douglas, 1994. "Information Revelation and Strategic Delay in a Model of Investment," Econometrica, Econometric Society, vol. 62(5), pages 1065-85, September.
  4. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121.
  5. Sobel, Joel, 1985. "A Theory of Credibility," Review of Economic Studies, Wiley Blackwell, vol. 52(4), pages 557-73, October.
  6. Cox, John C. & Ross, Stephen A., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 145-166.
  7. McDonald, Robert & Siegel, Daniel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, MIT Press, vol. 101(4), pages 707-27, November.
  8. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September.
  9. Robert J. Barro, 1986. "Reputation in a Model of Monetary Policy with Incomplete Information," NBER Working Papers 1794, National Bureau of Economic Research, Inc.
  10. Perotti, Enrico C & van Oijen, Pieter, 1999. "Privatization, Political Risk and Stock Market Development," CEPR Discussion Papers 2243, C.E.P.R. Discussion Papers.
  11. Perotti, Enrico C, 1995. "Credible Privatization," American Economic Review, American Economic Association, vol. 85(4), pages 847-59, September.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:cpr:ceprdp:2327. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()

The email address of this maintainer does not seem to be valid anymore. Please ask to update the entry or send us the correct address

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.