Political Risk and Irreversible Investment

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