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Investment under Threat of Disaster

Author

Listed:
  • Thomas Gries

    (University of Paderborn)

  • Natasa Bilkic

    (University of Paderborn)

Abstract

During the last 40 years the number and severity of economic, natural, and political disasters has significantly increased all over the world. Disasters are characterized by a highly uncertain frequency of occurrence and size of impact. Due to their relatively small probability, for a long time they were not regarded as an essential element of investment decisions. Although this has changed recently, especially in the context of specific applications in finance, a transfer to a general evaluation of disasters has not taken place yet. This paper shows how disastrous events of uncertain occurrence and uncertain size can be included in the most frequently used evaluation method, namely expected net present value (ENPV). We identify an Ito-Lévy Jump Diffusion process as an adequate stochastic process for this kind of phenomenon and determine how to account for such large uncertain events. We also illustrate that disregarding this phenomenon may easily lead to unprofitable investment behavior. Hence, disasters do have a huge impact on investment behavior and should be included into project evaluation.

Suggested Citation

  • Thomas Gries & Natasa Bilkic, 2014. "Investment under Threat of Disaster," Working Papers CIE 77, Paderborn University, CIE Center for International Economics.
  • Handle: RePEc:pdn:ciepap:77
    as

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    File URL: http://groups.uni-paderborn.de/wp-wiwi/RePEc/pdf/ciepap/WP77.pdf
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    disaster evaluation; large risk and uncertainty; non-marginal stochastic shocks; investment project evaluation;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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