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Currency Unions, Options, and Foreign Direct Investment

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  • Hisham Foad

Abstract

A multinational deciding on where to locate a foreign production facility may not be indifferent to the choice of location. Numerous variables such as production costs, market access, and local tax treatments will influence the decision as to where the plant is located. Another key variable in this decision is uncertainty. Following the work of Dixit, a firm has an option to make a risky investment, and if this investment is at least partially irreversible, the option has some positive value. As the uncertainty in the investment project increases, so too does the value of the option. When comparing two investment projects that are identical in all respects except their underlying profit volatility, the one with the greater degree of uncertainty will require a higher trigger level of profits to be exercised. This paper examines the impact of uncertainty in exchange rates on a multinational.s decision to locate within or outside a currency union. The option values and trigger levels of investment within and outside the union are derived as a function of exchange rate variances and correlations, transport costs, and market size.

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Paper provided by Department of Economics, Emory University (Atlanta) in its series Emory Economics with number 0516.

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Date of creation: Apr 2005
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Handle: RePEc:emo:wp2003:0516

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  1. Dixit, A., 1988. "Entry And Exit Decisions Under Uncertainty," Papers 91, Princeton, Department of Economics - Financial Research Center.
  2. Richard Baldwin & Paul R. Krugman, 1986. "Persistent Trade Effects of Large Exchage Rate Shocks," NBER Working Papers 2017, National Bureau of Economic Research, Inc.
  3. Goldberg, Linda S. & Kolstad, Charles D., 1994. "Foreign Direct Investment, Exchange Rate Variability and Demand Uncertainty," Working Papers 94-23, C.V. Starr Center for Applied Economics, New York University.
  4. Cushman, David O, 1985. "Real Exchange Rate Risk, Expectations, and the Level of Direct Investment," The Review of Economics and Statistics, MIT Press, vol. 67(2), pages 297-308, May.
  5. Sung, Hongmo & Lapan, Harvey E., 2000. "Strategic Foreign Direct Investment and Exchange Rate Uncertainty," Staff General Research Papers 1335, Iowa State University, Department of Economics.
  6. Gregory K. Bell & José M. Campa, 1997. "Irreversible Investments And Volatile Markets: A Study Of The Chemical Processing Industry," The Review of Economics and Statistics, MIT Press, vol. 79(1), pages 79-87, February.
  7. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September.
  8. Krugman, Paul, 1980. "Scale Economies, Product Differentiation, and the Pattern of Trade," American Economic Review, American Economic Association, vol. 70(5), pages 950-59, December.
  9. Campa, Joe Manuel, 1993. "Entry by Foreign Firms in the United States under Exchange Rate Uncertainty," The Review of Economics and Statistics, MIT Press, vol. 75(4), pages 614-22, November.
  10. Avinash Dixit, 1992. "Investment and Hysteresis," Journal of Economic Perspectives, American Economic Association, vol. 6(1), pages 107-132, Winter.
  11. Takao Itagaki, 1981. "The Theory of the Multinational Firm under Exchange Rate Uncertainty," Canadian Journal of Economics, Canadian Economics Association, vol. 14(2), pages 276-97, May.
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