Optimal Security Investments and Extreme Risk

Authors


At the time of this research was a PhD Student at the Department of Applied Economics, University of Minnesota, Minneapolis, MN, USA.

Hamid Mohtadi, Professor of Economics, PO Box 413, University of Wisconsin, Milwaukee, WI 53201 USA and Visiting Professor of Applied Economics, University of Minnesota, Minneapolis, MN; mohtadi@umn.edu.

Abstract

In the aftermath of 9/11, concern over security increased dramatically in both the public and the private sector. Yet, no clear algorithm exists to inform firms on the amount and the timing of security investments to mitigate the impact of catastrophic risks. The goal of this article is to devise an optimum investment strategy for firms to mitigate exposure to catastrophic risks, focusing on how much to invest and when to invest. The latter question addresses the issue of whether postponing a risk mitigating decision is an optimal strategy or not. Accordingly, we develop and estimate both a one-period model and a multiperiod model within the framework of extreme value theory (EVT). We calibrate these models using probability measures for catastrophic terrorism risks associated with attacks on the food sector. We then compare our findings with the purchase of catastrophic risk insurance.

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