Working Paper: CEPR ID: DP2327
Authors: Joseph A. Cherian; Enrico Perotti
Abstract: The paper analyzes 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.
Keywords: international asset pricing; political risk; option pricing; volatility; implied volatility
JEL Codes: F30; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| perceived political risk (P26) | appreciation of asset prices (G19) |
| stability of government policy (E60) | appreciation of asset prices (G19) |
| political risk (P26) | asset pricing dynamics (G19) |
| government actions (H59) | market responses (D49) |
| implied volatility from option prices exceeds actual volatility in scenarios without a policy reversal (E39) | perceptions of government credibility improve (H12) |
| timing of potential policy changes is strategically chosen by the government to attract capital (O24) | endogenous hazard rates of policy reversal (C41) |