JOURNAL OF ECONOMIC DEVELOPMENTVolume 23, Number 1, June 1998A Basic Model Incorporating Exchange Rate Riskin the Foreign Direct Investment DecisionGregory Clare**2This paper extends the discussion of exchange rate risk and its impact on a risk averse multinational undertaking foreign direct investment. Drawing on the economics and finance literatures, a basic model is presented which incorporates exchange rate risk into the firm’s objective function. The model highlights the problems created if exchange rate risk is not considered when determining the optimum level of capital and the effect of exchange rate movements on the firm’s cash flows, as well as how the standard responses to these movements impact the firm. Tax and host country policies are analyzed showing additional ways accounting for exchange rate risk affects the risk averse firm.I. IntroductionIssues relating to Foreign Direct Investment (FDI) during the past twenty years have generated a large literature. In an attempt to explain the existence of FDI, market imperfections of some sort have been assumed to exist (Ray (1977), Lunn (1980, 1983), Scaperlandra and Balough (1983), Scaperlandra and Mauer (1969), Aliber (1970, 1971), and Ragazzi (1973)). Some explain FDI as the result of a portfolio diversification process (Aggarwal (1977), Hartman (1977), and Rugman (1977)). In addition there have been studies concerned with why a foreign firm investing in a host country would have an advantage over local firms (Buckley and Dunning (1976), Buckley (1979)), why firms produce in the foreign market rather than service it through exports (Buckley and Dunning (1976), Buckley and Mathew (1979, 1980), and Lall (1980)), and why FDI exists rather than just licensing a local firm to produce and/or distribute the product (Contractor (1984))?With the collapse of the Bretton Woods system and it’s fixed exchange rate regime in the 1970’s, a further complication has been added to the FDI decision, namely “exchange rate risk”. Drawing on both the economics and finance literatures as a background, this paper presents a model of FDI which includes exchange rate risk explicitly in the investing firm’s objective function. In addition the model provides an analysis of the way both exchange rate movements and the generally recommended responses to these movements impact the firm. Finally, the model shows interesting effects form various tax and host country policies ** The author wishes to extend thanks to Ira Gang, Rich Mclean and Peter Loeb for their valuable comments throughout the various revisions of this paper. Thanks are also due to Bob Stuart and Dominick Salvatore as well. The author is also indebted for the valuable suggestions of an anonymous referee and the editor.** Department of Economics, Rutgers University, New Jersey Hall, 75 Hamilton St, New Brunswick New Jersey 08901-1248, U.S.A.
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