Title: Foreign Direct Investment and Forward Hedging
Reference Number: 1150
Publication Date: December 2005
JEL Classifcation: D81; F23; F31
Author(s):

Kit Pong Wong
The University of Hong Kong

Abstract:

This paper examines the behavior of a risk-averse multinational firm (MNF) making investment in a foreign country under exchange rate uncertainty. To hedge the exchange rate risk, the MNF has access to an unbiased currency forward market. Foreign direct investment (FDI) is irreversible and sequential in that the MNF can acquire additional capital after the exchange rate uncertainty is completely resolved. The MNF as such possesses a real (call) option that is rationally exercised whenever the foreign currency has been substantially appreciated relative to the domestic currency. We show that the MNF's optimal initial level of sequential FDI is always lower than that of lumpy FDI, while the expected optimal aggregate level of sequential FDI can be higher or lower than that of lumpy FDI. We further show that the presence of the currency forward market improves the MNF's incentives to make FDI, both ex ante and ex post.

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Key words: Foreign direct investment; Real options; Currency forwards

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Last modified: 03/28/2006