Investment under Threat of Disaster

Thomas Gries and Natasa Bilkic ()
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Natasa Bilkic: University of Paderborn

No 77, Working Papers CIE from Paderborn University, CIE Center for International Economics

Abstract: During the last 40 years the number and severity of economic, natural, and political disasters has significantly increased all over the world. Disasters are characterized by a highly uncertain frequency of occurrence and size of impact. Due to their relatively small probability, for a long time they were not regarded as an essential element of investment decisions. Although this has changed recently, especially in the context of specific applications in finance, a transfer to a general evaluation of disasters has not taken place yet. This paper shows how disastrous events of uncertain occurrence and uncertain size can be included in the most frequently used evaluation method, namely expected net present value (ENPV). We identify an Ito-Lévy Jump Diffusion process as an adequate stochastic process for this kind of phenomenon and determine how to account for such large uncertain events. We also illustrate that disregarding this phenomenon may easily lead to unprofitable investment behavior. Hence, disasters do have a huge impact on investment behavior and should be included into project evaluation.

Keywords: disaster evaluation; large risk and uncertainty; non-marginal stochastic shocks; investment project evaluation (search for similar items in EconPapers)
JEL-codes: D81 G11 (search for similar items in EconPapers)
Pages: 20 pages
Date: 2014-02
New Economics Papers: this item is included in nep-ppm
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Persistent link: https://EconPapers.repec.org/RePEc:pdn:ciepap:77

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