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Investment Decisions under Real Exchange Rate Uncertainty

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  • Bahar Erdal

Abstract

This paper analyzes the depressing effects of real exchange rate uncertainty on investment spending by using option pricing techniques. Investment under uncertainty assumes that investments are irreversible and can be delayed to wait for new information about prices, exchange rates and other macroeconomic variables. Irreversible investment spending is like a financial call option. When the opportunity to undertake irreversible investment is exercised, it kills the option of investing and the possibility of waiting for new information. Therefore, investment decisions of firms are sensitive to uncertainties over economic environment. Assuming present real exchange rate volatility is a proxy for real exchange rate uncertainty, and investment spending is like a call option, this paper shows that real exchange rate volatility causes optimal real exchange rate level to undertake investment to be higher for export-oriented sectors and lower for import-oriented sectors. Thus, the zone of "inaction" increases, and real investment spending falls as volatility increases regardless of whether the sector is an export-oriented or import-oriented sector.

Suggested Citation

  • Bahar Erdal, 2001. "Investment Decisions under Real Exchange Rate Uncertainty," Central Bank Review, Research and Monetary Policy Department, Central Bank of the Republic of Turkey, vol. 1(1), pages 25-47.
    • Handle: RePEc:tcb:cebare:v:1:y:2001:i:1:p:25-47
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    References listed on IDEAS

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    Cited by:

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    2. Mourad Zmami & Ousama Ben-Salha, 2015. "The adjustment of plant-level investment to exchange rate fluctuations in Tunisia: do the size and the ownership structure matter?," Economics Bulletin, AccessEcon, vol. 35(4), pages 2487-2505.
    3. José Mauricio Gil León & Daniel Eduardo Silva-Pinzón, 2019. "Índice de incertidumbre de política económica (EPU) para Colombia, 2000-2017," Ensayos de Economía 18198, Universidad Nacional de Colombia Sede Medellín.
    4. Aytekin GÜVEN & Arzu AKKOYUNLU-WIGLEY, 2018. "The Effects of Market Structure on Uncertainty-Investment Relationship: Evidence from Turkish Manufacturing Industry," Sosyoekonomi Journal, Sosyoekonomi Society, issue 26(37).
    5. Qi, Jianhong & Liu, Hui & Zhang, Zhaoyong, 2021. "Exchange rate uncertainty and the timing of Chinese Outward Direct Investment," International Review of Economics & Finance, Elsevier, vol. 76(C), pages 1193-1204.

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    More about this item

    Keywords

    Real Exchange Rate; Uncertainty; Investment;
    All these keywords.

    JEL classification:

    • C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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