Option pricing and foreign investment under political risk

The paper analyses asset prices in a context of uncertainty over future government policy. As current policy is maintained, perceived risk abates thus leading to a gradual appreciation of asset prices and a gradual decrease in their conditional variance. Option values computed under this process have time series and the term structure of conditional volatility, which, in general, are downward sloping. In price series without a policy reversal, implied volatility from option prices will exceed actual volatility, with this wedge progressively disappearing. This may be viewed as the volatility analogue of the 'peso premium' for assets subject to large, infrequent price drops. (C) 2001 Elsevier Science B.V. All rights reserved.