Valuing Political Risk

In this paper, I develop a model that measures the effects of political risk on the outcome of a foreign direct investment project as the value of an insurance policy that reimburses all losses resulting from the political event or events in question. The evolutionary process of political risk is explicitly defined and includes a stochastic element as well as the timing of the political events that trigger losses. All parameters can be estimated from current data which eliminates the difficulty of forecasting political events far into the future. Valued in this way, political risk enters the capital budgeting process directly as a cost. Finally, I simulate the model's use for the case of expropriation and the case of a series of losses