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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.

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

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Date of creation: Dec 1999
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Handle: RePEc:cpr:ceprdp:2327
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  1. Thomas, Jonathan & Worrall, Tim, 1994. "Foreign Direct Investment and the Risk of Expropriation," Review of Economic Studies, Wiley Blackwell, vol. 61(1), pages 81-108, January.
  2. 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.
  3. Gale, D. & Chamley, C., 1992. "Information Revelation and Strategic Delay in a Model of Investment," Papers 10, Boston University - Department of Economics.
  4. Sobel, Joel, 1985. "A Theory of Credibility," Review of Economic Studies, Wiley Blackwell, vol. 52(4), pages 557-73, October.
  5. 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.
  6. Jonathan Eaton & Mark Gersovitz & Joseph E. Stiglitz, 1986. "The Pure Theory of Country Risk," NBER Working Papers 1894, National Bureau of Economic Research, Inc.
  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., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 145-166.
  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.
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