Doctoral Dissertations

Date of Award

12-1987

Degree Type

Dissertation

Degree Name

Doctor of Philosophy

Major

Economics

Major Professor

George C. Philippatos

Committee Members

Don P. Clark, Hui S. Chang, William C. Cole, Dosoung Choi

Abstract

The purpose of this dissertation is to examine both theoretically and empirically the effects of exchange rate risk on the distributional pattern of foreign dlj.rect investment (FDI) and to discuss some Of the implications.

The increase in exchange rate fluctuations since the advent of the floating exchange rate system has intensified research interest about the effects of such fluctuations on the flow of FDI. A considerable literature in the field now exists which analyzes the effects of exchange rate levels on FDI, and a majority of the studies show that the devaluation of a country's currency discourages the outflow of FDI and encourages the inflow of FDI. However, research that combines both theoretical and empirical aspects of the relationship between exchange rate risk and FDI has not been sufficient to date.

Consequently, in this study a simple theoretical model of FDI is developed in which measurement of exchange rate risk and its theoretical linkage with FDI are constructed within the framework of the Capital Asset Pricing Model (CAPM). It is shown that exchange rate risk, via risk-adjusted net present value of foreign profits, negatively affects the FDI decision of the multinational enterprise (MNE). This theoretical framework is then adapted for econometric testing using various proxies for exchange rate risk which can be quantified with the help of a broader version of the financial asset pricing paradigm -- such as the multi-factor asset pricing model. Moreover, the implications for the behavior of the MNE in the presence of exchange rate risk are studied by analyzing the sensitivity of cash flows of the MNE with respect to exchange rate risk.

A pooled time-series and cross-sectional econometric technique is used to test the model, using annual FDI flows from the U.S. to eleven major OECD countries for the period 1974-1984. Various statistical methods applied to the pooled data set are employed for the purpose of comparison.

The empirical results indicate that the exchange risk variable is not a significant determinant for FDI, regardless of the measure employed for exchange rate risk. However, strong evidence is presented for the hypothesis that FDI is made in the form of labor-intensive processes in labor-abundant countries in the presence of exchange risk. Combined with earlier findings, that evidence leads us to venture a tentative inference that, although direct investment decisions by MNEs do not seem to be affected by exchange rate risk, MNEs attempt to allocate their foreign investments among countries to reduce the exposure of foreign cash flows to exchange risk. The results of the study thus provide some insights into the investment decision-making behavior of MNEs that are subject to uncertain exchange risk as well as implications for the theory of MNE and exchange rates.

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