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CESifo Economic Studies 2007 53(3):430-465; doi:10.1093/cesifo/ifm014
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Right arrow O11 - Macroeconomic Analyses of Economic Development
Right arrow O16 - Economic Development: Financial Markets; Saving and Capital Investment; Corporate Finance and Governance
Right arrow D92 - Intertemporal Firm Choice and Growth, Investment, or Financing
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© The Author 2007. Published by Oxford University Press on behalf of Ifo Institute for Economic Research, Munich. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org

Political Risk and Irreversible Investment

Sumru G. Altug*, Fanny S Demers{dagger} and Michel Demers{dagger}

*Koç University, Istanbul, Turkey and Centre for Economic Policy Research, London, UK, e-mail: saltug{at}koc.edu.tr
{dagger}Carleton University, Canada, e-mail: fdemers{at}connect.carleton.ca and mdemers{at}connect.carleton.ca

The objective of this article is two-fold. First, we develop a theoretical model to investigate the impact of political risk on irreversible investment. Second, we apply our model to an analysis of the effects of risk of separation of the province of Quebec from the Canadian federation. We model the probability of a regime switch using the properties of the electoral process and examine the response of investment to changes in the risk of separation. We consider the impact of investors' perception of the risk of separation and financial market volatility separately. We show that political risk has a depressing impact on investment even if the "bad" regime has never been observed in the sample. (JEL Codes: E22, D92, O16, O11)

Key Words: Irreversible investment • political risk • regime shifts • Quebec investment • Canada.


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