Constructing a Positive Shock: Growth Through the Lens of Option Pricing

IMF Working Papers, July 28, 2023

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Low-income economies face negative shocks whose frequency and disproportionate impact overcome growth trajectories, producing a negative drift.
COVID-19 is identified as the latest such episode.
To escape this negative drift and build a durable recovery, there is a need for a counter-balancing force: to construct a positive shock.
Growth is realized through decisions that fall under two categories: routine and non-linear.
Routine decisions modify existing economic behavior along the same path; non-linear decisions describe riskier options that involve transformation.
Option pricing theory can be useful to describe non-linear decisions and to construct the positive shock required to escape the negative drift.

Negative shocks occur with sufficient frequency and disproportionate impact to create a negative drift in low-income economies.
Routine decisions alone are insufficient to reverse the negative drift.
Non-linear, transformation-oriented decisions are necessary to produce a positive shock capable of changing growth trajectories.
Option pricing theory provides a conceptual and analytical framework to model and value these non-linear, riskier options.

Distinction between two decision types:
- Routine decisions: modifications of existing economic behavior along the same path.
- Non-linear decisions: riskier, transformative options that can generate a positive shock.
Use of option pricing theory to represent and price transformative investment opportunities that can alter growth dynamics.

Policymakers in low-income economies should prioritize creating conditions that enable non-linear, transformative decisions capable of producing positive shocks.
Standard policy responses that only support routine decisions are unlikely to be sufficient to overcome persistent negative drift.
Leveraging frameworks from option pricing theory can inform the design and assessment of policies that aim to stimulate transformative investment and escape negative growth trajectories.