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Which foreign investors worry about foreign exchange risk in South Asia and why?

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  • Bond, Eric
  • Estache, Antonio
  • DEC

Abstract

The authors show that the potential benefit to a host country of forward markets or of foreign exchange guarantees depend on the investor's country of origin and on specific characteristics of investment. They show this in terms of the effects on foreign-exchange risks and on the amount of foreign direct investment taking place. Their main lessons for foreign investors: (a) the benefits of hedging exchange risks through forward markets vary substantially, depending on the investor, the type of investment, and, for foreign direct investment (FDI), the direction of the market supplied; (b) for short lived investment or FDI targeted to the host country market, the potential for gain from forward contracts is substantial because in the short run, nominal exchange rate fluctuations tend to be larger than real exchange rate fluctuations; (c) for long-lived investments or export oriented FDI, the gains from forward contracts will be much smaller. Firms investing in long lived assets or in activities targeted to exports net natural insurance from the correlation between the nominal exchange rate and the firm's earnings in host-country currency; and (d) the evidence on exchange rate and price fluctuations between 1975 and 1991 suggests that the demand for coverage is likely to be stronger in South Asia than in Latin America. In East Asia, the evidence is mixed. Their main lessons for host country governments: (a) in the short run, if there are no private forward markets, the optimal policy for a risk-neutral host country is to provide the firm with forward contracts at the expected spot exchange rate. This government insurance has the same effects as allowing trading in forward markets. But these contracts can have fiscal consequences, as they did in Latin America; (b) forward markets do not discriminate against host country firms. Those engaged in international trade can also benefit from the presence of forward markets; and (c) in the medium run, as exchange controls are being liberalized, forward markets may be slow to develop because of participants'uncertainty about their ability to get foreign currency to cover forward commitments. In this transitional period, contracts offered by the government are likely to be the most efficient means of reassuring foreign investors. These contracts should also be make available to host-country firms during the transitional period, in order not to discriminate against domestic investors.

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Bibliographic Info

Paper provided by The World Bank in its series Policy Research Working Paper Series with number 1344.

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Date of creation: 31 Aug 1994
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Handle: RePEc:wbk:wbrwps:1344

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Keywords: Economic Theory&Research; Environmental Economics&Policies; Financial Intermediation; Banks&Banking Reform; Economic Stabilization;

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  1. Capel, Jeannette, 1992. "How to service a foreign market under uncertainty: A real option approach," European Journal of Political Economy, Elsevier, vol. 8(3), pages 455-475, October.
  2. Dixit, Avinash K, 1989. "Entry and Exit Decisions under Uncertainty," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 97(3), pages 620-38, June.
  3. Nance, Deana R & Smith, Clifford W, Jr & Smithson, Charles W, 1993. " On the Determinants of Corporate Hedging," Journal of Finance, American Finance Association, vol. 48(1), pages 267-84, March.
  4. Broll, Udo & Wahl, Jack E., 1992. "International investments and exchange rate risk," European Journal of Political Economy, Elsevier, vol. 8(1), pages 31-40, February.
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