Option Pricing and Foreign Investment under Political Risk

Option Pricing and Foreign Investment under Political Risk

University of Amsterdam; Centre for Economic Policy Research (CEPR)
Boston University - School of Management

The paper analyses 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.

JEL Classifications: F21, F34, G13, G38

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Contact Information for ENRICO C. PEROTTI (Contact Author)

E.C.Perotti@uva.nl (Email address for ENRICO C. PEROTTI )
University of Amsterdam
Roetersstraat 18
Finance Group
Amsterdam 1018 WB
+31 20 525 4159 (Phone)
+31 20 525 5285 (Fax)

(No e-mail address available for ENRICO C. PEROTTI )
Centre for Economic Policy Research (CEPR)
90-98 Goswell Road
London EC1V 7RR
United Kingdom

Contact Information for JOSEPH A. CHERIAN

Boston University - School of Management
595 Commonwealth Avenue
Boston , MA 02215
United States
617-353-2679 (Phone)
617-353-6667 (Fax)

Suggested Citation
Perotti, Enrico C. and Cherian, Joseph A., "Option Pricing and Foreign Investment under Political Risk" (September 1999). http://ssrn.com/abstract=162348

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