Foreign Direct Investment : The Incentive to Expropriate and Expropriation Risk

This paper examines FDI and expropriation in an economic framework that opposes the government's incentive to expropriate with the firm's cost of expropriation risk. Using standard methods of stochastic calculus, the value of expropriation to the government is modeled as a function of the value of the FDI, which fluctuates randomly over time. The cost of expropriation risk to the firm is modeled as the value of an insurance policy that pays off all net losses resulting from expropriation. It is shown that the firm's cost of expropriation risk depends on how the host government perceives the cost it will incur in the expropriation. Focusing on this cost, it is shown that when information is complete, expropriation is always successful for the host government. When information is incomplete, expropriation for the host government is assured of being successful only when the government knows the true expropriation costs. For the firm, incomplete information always causes a dilemma, even when it is the firm that possesses monopolistic information. When expropriation costs vary stochastically, three new parameters enter the analysis: the growth rate of the costs, their volatility and their correlation with the value of the investment