Pricing the Cost of Expropriation Risk

This paper develops a model for evaluating the cost of expropriation risk, which is determined with respect to the government's incentive to expropriate. The model includes the positions of both government and firm. The government's decision to expropriate is modeled as an American style call option whose value depends on the amount to be gained in the case of expropriation and the costs that will be inflicted on the country if the act of expropriation is actually carried out. The cost of expropriation risk is modeled as the value of a hypothetical insurance policy that pays off all losses to the firm resulting from expropriation. The firm's cost of expropriation risk is determined by the government acting to optimize the value of its option to expropriate. The model makes it possible to identify the parameters and the relationships among these parameters that link the government's option to expropriate to the firm's cost of expropriation risk. I then show how the parameters can be estimated and the model applied in capital budgeting decisions and the ongoing management of expropriation risk. I also show how and why the value of the government's option to expropriate is likely to differ from the firm's cost of expropriation risk