Mitigation of Foreign Direct Investment Risk and Hedging. Jack E. Wahl* Udo Broll

Transcription

1 Mitigation o Foreign Diret Investment Risk an Heging Jak E. Wahl Uo Broll Abstrat Instruments o risk mitigation play an important role in managing ountry risk within the oreign iret investment (FDI) eision. Our stuy assesses ountry risk by state-epenent preerenes an introues utures ontrats as a tool o risk mitigation. We show that oreign iret investment relate ountry risk assessments o not matter i the multinational irm enters urreny utures markets. Besies urreny risk multinationals ross-hege ountry risk via the erivatives market. This may explain the empirial result, why host ountry risk is not a signiiant eterminant o FDI (Bevan/Estrin 24) together with the at that almost all (92 %) o the worl s top 5 ompanies enter erivatives markets or heging purposes (ISDA 28). JEL Classiiation: F21, F23, G32 Keywors: state-epeneny, ountry risk, oreign iret investment, heging. We woul like to thank the partiipants o the workshop Country Risk an FDI at Dresen University o Tehnology or their omments an isussions. Espeially, we woul like to thank Frano Reither, an our isussant, Alexaner Kemnitz, or their omments. Last but not least, we woul like to thank the anonymous reerees or their suggestions whih helpe to improve the paper.. Department o Finane, Dortmun University o Tehnology, Dortmun, Germany, ax , jak.wahl@uo.eu Corresponene to: Uo Broll, Department o Business Management an Eonomis, Dresen University o Tehnology, 162 Dresen, Germany, ax , uo.broll@tu-resen.e 21 Eletroni opy available at:

2 Jak E. Wahl, Uo Broll - Mitigation o Foreign Diret Investment Risk an Heging 1 - Introution Multinational irms are key players in globalize eonomies. Multinationals are oten ierent rom purely national irms. They are relatively large, they have power in the market plae an bargaining power in the poliy making arena, partiularly in transition eonomies an eveloping ountries. They are able to move ativities between their plants at relatively low ost, removing beneits as rapily as they eliver them. 1 However, it is well known that oreign portolio or oreign iret investment (FDI) suer rom politial as well as eonomi risk. The reason or politial risk is that there is no legal reourse i the host ountry government hooses to eault on a ebt ontrat or expropriate a real or inanial asset. Thereore, the global business environment that multinational irms ae epens upon the poliies that iniviual nations pursue. Hene, the multinational irm must assess the ountry's risk proile by stuying the linkage between the ountry's eonomis poliies an the egree o eonomi risk. 2 Country risk an be separate into six main ategories o risk: eonomi risk, transer risk, exhange rate risk, loation risk, sovereign risk an politial risk. Given the reognition o these kins o ountry risk, the multinational irm has at least our poliies to manage ountry risk: avoiane, insurane, struturing the investment an negotiating with the host ountry government. 3 This paper is an extension o the theory o the multinational irm with speial emphasis on the impat o ountry risk an state-epenent preerenes. The purpose o the stuy is to introue the state-epeneny o preerenes to aount or ountry risk in a broaer sense. For the basi onept o state-epenent preerenes, we reer to Karni 1985; some appliations are given by Karni 1983, Broll/Ekwert 1998, Broll/Wong 22. Suppose that ountry risk is generate by an unerlying risk soure, e.g. the business yle. We propose a iret impat o the risk soure upon preerenes, sine in very ba states o nature o eonomi poliy o the host 1 For ats an issues about multinational irms, see, Navaretti/Venables 24, Shmit/Broll See, or example, Bouhet/Clark/Groslambert 23, Navaretti/Venables 24, Altug/Demers/ Demers 27, Wagner 27, OECD See, Shapiro Eletroni opy available at:

3 Jak E. Wahl, Uo Broll - Mitigation o Foreign Diret Investment Risk an Heging ountry the probability o survival o the oreign iret investment onstitutes a relevant eision riterion or the multinational irm besies expete proits an proit risk. In our eonomi setting (setion 2) we woul like to know whether or not the well-known separation theorem an the ull-hege theorem are still vali in a state-epenent utility ramework o a multinational irm with oreign iret investment. The analysis is organize as ollows: In setion 2 the moel o a multinational irm with oreign iret investment is presente. The eet o ountry risk on international apital alloation is investigate. In setion 3 the impat o ountry risk with state-epenent preerenes on oreign iret investment an risk mitigation is analyze. We emonstrate that the separation theorem hols whereas the ull-hege theorem is violate. Finally, in setion 4, we onlue the paper ater some general remarks. 2 - FDI uner ountry risk Our investigation rests on the ollowing set o assumptions: We onsier a multinational irm with apital stok K. The irm alloates investments Z abroa an K Z at home. The oreign iret investment Z is positive i the Inaa-onitions hol. 4 The irm s omesti proit reas ( K Z). The stohasti oreign proit, enominate in omesti urreny, is given by ( ; Z ), where assesses ountry risk. 5 The ountry risk may onsist o eonomi risks, transer risks, exhange rate risk, sovereign risk, politial risks, business yle risk. 6 It auses the unertainty o the multinational irm s total proit, whih reas ( K Z) ( Z; ), (1) i the multinational irm has no aess to any heging opportunities. 7 4 See, Inaa For an extension, see Barelli/Abreu Pessôa Ranom variables have a tile, while their realisations o not. 6 See, Hauser 26, p We introue utures-heging in setion 3. 23

4 Jak E. Wahl, Uo Broll - Mitigation o Foreign Diret Investment Risk an Heging With respet to oreign proit, realisations o the ountry risk measure 2 have the ollowing impat: / an / / Z, i.e., oreign proit an marginal oreign proit beomes larger when higher realisations o the measure our. Optimum FDI eision uner risk averse behaviour o the irm 8 ollows rom maximizing expete utility o a twie-ierentiable von Neumann-Morgenstern utility untion U ( ). Marginal utility is positive, i.e. U ' an ontinuously ereasing an ierentiable, i.e. U '' : where E enotes the expetation operator. max EU ( ), (2) The irst-orer onition or optimum FDI yiels: Z EU ( )( ( K Z ) ( Z ; )). (3) Given the proit motive to invest abroa, risk aversion an oreign proit harateristis imply ov( U ( ), ( Z ; )). This leas to E ( Z ; ) ( K Z ). (4) Hene there is a positive expete proit margin to FDI. The extent o FDI, Z, epens upon apital stok, preerenes an expetations o the multinational irm. Consier optimum FDI uner ertainty, Z, that is to say uner a non-risky ountry speii parameter. Optimum FDI has to satisy ( Z ; ) ( K Z ). 8 There exists a thorough isussion about managerial risk aversion as a rationale or orporate risk management. One important argument is the existene o apital market imperetions (see, e.g., Froot/Sharstein/Stein 1993), estroying the Moigliani-Miller theorem. 24

5 Jak E. Wahl, Uo Broll - Mitigation o Foreign Diret Investment Risk an Heging Let us now analyze the so-alle ertainty equivalent ase 9, i.e. E ( Z ; ) ( Z ; )). We obtain ( K Z ) ( K ). Hene Z Z Z, sine the irm s marginal proit is ereasing. Thereore, introuing ountry risk reues the amount o oreign iret investment. Result 1: I ountry risk ours, FDI lessens. 3 - FDI an heging uner ountry risk In what ollows we stuy the inentive o the risk averse multinational irm to mitigate the eet o ountry risk on FDI by entering the utures market. Thereby we also introue an motivate the notion o state-epenent utility when investigating on the ountry risk problem. 3.1 FDI an utures-heging Let us onsier the speial soure o ountry risk, namely the oreign exhange rate risk. Current empirial literature reports that exhange rate risks seem to be the most important soure o risk rom the point o view o multinational enterprises in transition eonomies (Hauser 26, Table 2.1). We thereore ientiy the ountry risk parameter as to be the risky oreign exhange rate e. We stuy the ollowing eonomi setting: The irm enters the urreny utures market by selling or buying utures ontrats, given the oreign exhange orwar rate e. The oreign urreny heging volume is enote by H. While the market prie e oes not epen upon the irm s heging poliy, the ontratual amount H is ontingent on e. With respet to ountry risk we stuy a multipliative risk. We set the ollowing Assumption: ( Z; e) ( Z) e, or all e, an (Z) enominates in oreign urreny. 9 See, e.g., Kawai/Zilha

6 Jak E. Wahl, Uo Broll - Mitigation o Foreign Diret Investment Risk an Heging Hene the unertain total proit o the multinational irm beomes: ( K Z) ( Z) e ( e e ). (5) H The irst-orer onitions or optimum FDI an heging are given by: EU ( )( ( ) ( ) K Z h Z h e ), (6) EU ( )( e e ), (7) where Z h enotes optimum FDI uner utures-heging. Aing both equations yiels ( K Z h ) ( Z h ) e. Thereore the separation theorem 1 hols an we obtain the ollowing Result 2: The FDI eision o the multinational irm oes neither epen upon the irm s egree o risk aversion nor upon the irm's assessment o the oreign exhange rate risk. The essentials are orwar oreign exhange rate, apital stok an marginal omesti an oreign proit. Two multinational irms whih are iential regaring these essentials will take the same FDI eision espite o ierenes in risk aversion or assessments o ountry risk. The heging optimality onition gives ) ( EU ( )( e ( )( )) ov( ( ), e EU e E e U e ). (8) Sine expete marginal utility o proits is stritly positive the sign o the ovariane ollows the sign o the premium ( e E( e )). Hene we obtain that sgn ( e ( E e )) sgn ov ( U '( ), e ). Let us rewrite proits as 1 See, e.g., Broll/Wahl

7 Jak E. Wahl, Uo Broll - Mitigation o Foreign Diret Investment Risk an Heging e ( ) ( ( ) ) H K Z Z H e. It ollows the ull-hege theorem: 11 sgn ( H ( Z h )) sgn ( e ( E e )), or marginal utility o proits is ontinuously ierentiable an monotonially ereasing. Result 3: The multinational irm ully (uner-)[over-]heges oreign proits i, an only i, the orwar rate is air (in bakwaration)[in ontango]. Uner utures-heging the ertainty equivalent omparison leas to Z Z h, sine or onsisteny the orwar rate has to be set equal to the ertain oreign exhange rate. 3.2 FDI an state-epeneny In setion 3-1 preerenes are assume to be state-inepenent. The moel o this setion is intene to be use as a benhmark. Typially, preerenes o a irm are state-epenent (Karni 1983, an Zilha 1987). In general, the irm s eision making uner unertainty will be aete, beause ierenes in the eet o risk our. Hene the state-epeneny o the multinational irm s preerenes is an important eature o proution an heging eisions. Creeping expropriation, inseure property rights ue to weak institutions an politial turnaroun name important soures o ountry risk. In very ba states o nature the oreign iret investments o the multinational irm may then be highly at risk. I the probability o the survival o the oreign venture onstitutes an important eision riterion besies expete proits an oreign exhange risk preerenes are aete. Hene, important aspets o ountry risk iretly proue a hange o preerenes by altering risk attitue. Thereore, state-epenent utility seems an appropriate approah when speii soures o ountry risk ominate. Whether or not the irm s business outlook is goo or ba may then onstitute a ierene in the preerenes struture. 11 See, e.g., Broll/Wahl

8 Jak E. Wahl, Uo Broll - Mitigation o Foreign Diret Investment Risk an Heging Let s enote an aggregate measure o the unertain state o nature. The oreign exhange rate as well as the utility untion epen upon the realisations o this risk measure: s (risk soure) U ( ( e); s) (utility) e (FX spot rate) For instane, state s may be the multinational irm's state o being on the verge o ailure in the host ountry. It aets the irm's preerenes iretly, an iniretly through the oreign exhange spot market. Hene, marginal utility is aete iretly an iniretly. It will be shown that the irm s heging poliy takes all risk eets into aount. While uner stateinepenent utility an unbiase orwar rate, i.e. e E(e ), allows or a risk-ree proit by a unit hege ratio, uner state-epenent utility a ull-hege is not optimal in this ase an the proit o the multinational irm remains risky. Hene risk eets on proits ier when preerenes beome stateepenent. Optimum FDI an heging eisions o the multinational irm ollow rom maximizing expete state-epenent utility: max EU ( ; s ). (9) Z, H Calulating the irst-orer onitions yiels: ; EU ( s )( ( ) ( ) K Zs Zs e ), (1) EU ( ; s )( e e ), (11) 28

9 Jak E. Wahl, Uo Broll - Mitigation o Foreign Diret Investment Risk an Heging where Z s enotes optimum FDI uner state-epeneny o preerenes. By aing both equations we get ( K Z s ) ( Z s ) e an we obtain the ollowing Result 4: With state-epenent preerenes an the use o a urreny utures market the separation theorem hols. Aitionally, the stateepeneny o the irm's preerenes oes not aet the irm's FDI eision. Result 5: The ull-hege theorem oes not hol. An unbiase urreny utures market, i.e. e E(e ), implies rom the optimum hege onition that ov( U ( ; s ), e ). While a ull hege, i.e. H ( Z s ), woul eliminate urreny risk, marginal utility woul still be risky beause o state-epeneny. In general, heging poliy has to aount or the ountry risk by reraining rom a ull hege, whih violates the ull-hege theorem. Hene, the irm uses the opportunity to ross-hege ountry risk via utures-heging. 3.3 FDI an mean-variane For explanatory reasons let us investigate the relate mean-variane moel. We onsier the preerene untion U V (, ) whih possesses the neessary properties. 12 Expete proits are state-epenent an given by E( s ). The variane o proits, or simpliity, is assume to be: 2 var( ). In other wors, while expete proits exhibit a tren shok, proit risk oes not. Notwithstaning, the variane o proits epens upon the state variable s, sine optimum proits epen upon the realisation o the state variable. Hene both arguments in the preerene untion are aete by ountry risk See Meyer 1987, Battermann/Broll/Wahl 22, Broll/Wahl/Wong State-epenent proit risk, i.e. var( s ) involves signiiant tehnial problems, sine the variane o a prout o ranom variables is onsiere (see Bohrnstet/Golberger 1969), without aing muh to eonomis. 29

10 Jak E. Wahl, Uo Broll - Mitigation o Foreign Diret Investment Risk an Heging Maximizing the preerene untion V (, ) with respet to the amount o oreign iret investment Z an the oreign urreny heging volume H yiels the ollowing irst-orer onitions: E( s ( ( Z ) e ( K Z ))) R ( ( Z ) H ) ( Z [ )] 2 E s ( e e R ( ( Z ) H ), e 2 ), 2 where var( e ) is the exogenous risk o the oreign exhange rate an e 1 R is the risk aversion measure. From the seon optimum onition the irm s heging poliy has to satisy: e H Z E[ s ( e )] e ). R ( 2 e For our eonomi setting, with the assumption, that the urreny utures market is unbiase, i.e. e E(e ), an that, thereore, E [ s ( e e )] ov( s, e ) we obtain or the the irm s ontratual e heging volume: H ( )[ ] ( Z ) i, an only i, ov[ s, e ] ( )[ ]. The eonomi intuition or the irm s risk mitigation poliy using oreign urreny utures is the ollowing: Diversiiation pays, sine urreny utures ross-hege business yle risk. This result ollows rom the at that the FDI eision is separable rom the heging eision. Result 5: Futures-Heging mitigates the impat o the risk soure on preerenes by iversiiation: The less positively orrelate the risk soure (e.g., the business yle) with the oreign urreny, the higher the eman or utures ontrats. 3

11 Jak E. Wahl, Uo Broll - Mitigation o Foreign Diret Investment Risk an Heging 4 Conlusion Country risk analysis attempts to ientiy imbalanes that inrease the risk o a iret investment in a oreign ountry. This paper esribes the interation between inanial instruments o risk mitigation in managing ountry risk within the iret investment eision o a multinational irm. We emonstrate that i ountry risk onsierations lea to a stateepeneny o preerenes the separation theorem hols, i.e., it is rational to separate the FDI eision rom the heging eision an negleting preerenes an ountry risk assessments. But the ull-hege theorem is violate an utures-heging, whih aounts or preerenes an expetations, beomes a omplex poliy. Suppose that in very ba states o nature the probability o ailure o the oreign iret investment onstitutes an important eision riterion or the multinational irm besies expete proits an risk. Then this aspet o ountry risk an be mitigate by utures-heging, sine entering the utures market enables the multinational irm to ross-hege ountry risk. Beause o the inentive o the multinational irm to iversiy risks, the eman or urreny utures ontrats inreases when the risk soure (e.g., the business yle) beomes less orrelate with the oreign exhange rate. The paper onlues that risk assessments relate to the oreign iret investment eision o not matter i the multinational irm enters a urreny utures market. Furthermore, state-epeneny o the preerenes o the multinational irm plaes aitional emphasis on orporate utures-heging, sine the eman or utures ontrats is also onerne with ountry risk. Reerenes Altug, S.G., F.S. Demers an M. Demers, 27. Politial risk an irreversible investment. CESio Eonomi Stuies 53, Battermann, H.L., U. Broll an J.E. Wahl, 22. Insurane eman an the elastiity o risk aversion. OR Spetrum 24, Barelli, P. an S. e Abreu Pessôa, 23. Inaa onitions imply the proution untion must be asymptotially Cobb-Douglas. Eonomis Letters 81, Bevan, A.A. an S. Estrin, 24. The eterminants o oreign iret investment into European transition eonomies. Journal o Comparative Eonomis 32,

12 Jak E. Wahl, Uo Broll - Mitigation o Foreign Diret Investment Risk an Heging Bohrnstet, G.W. an A.S. Golberger, On the exat ovariane o prouts o ranom variables. Amerian Statistial Assoiation Journal 64, Bouhet, M.H., E. Clark an B. Groslambert, 23. Country Risk Assessment. (John Wiley an Sons, Lonon). Broll, U. an B. Ekwert, Export an heging eision with stateepenent utility. International Review o Eonomis an Finane 7, Broll, U. an J.E. Wahl, Multinational irm, oreign proution, an heging behaviour. Sottish Journal o Politial Eonomy 4, Broll, U., J.E. Wahl an W.-K. Wong, 26. Elastiity o risk aversion an international trae. Eonomis Letters 92, Broll, U. an K.P. Wong, 22. Optimal ull-heging uner state-epenent preerenes. Quarterly Review o Eonomis an Finane 42, Froot, K.A., D.D Sharstein an J.C. Stein, Risk management: oorinating orporate investment an inaning poliies. Journal o Finane 48, Hauser, F., 26. Country risk an oreign iret investments in transition ountries. (Ph.D. thesis at LMU Munih, Germany). ISDA, 28. Researh Notes o the International Swaps an Derivatives Assoiation. New York et al. Inaa, K.-I., On a two-setor moel o eonomi growth: omments an a generalization. The Review o Eonomi Stuies 3, Karni, E., Risk aversion or state-epenent utility untions: Measurement an appliations. International Eonomi Review 24, Karni, E., Deision Making Uner Unertainty: The Case o State- Depenent Preerenes. (Harvar University Press, Boston, MASS). Kawai, M. an I. Zilha, International trae with orwar-utures markets uner exhange rate an prie unertainty. Journal o International Eonomis 2, Meyer, J Two-moment eision moels an expete utility maximization. Amerian Eonomi Review 77, Navaretti, G.B. an A.J Venables, 24. Multinational Firm in the Worl Eonomy. (Prineton University Press, Prineton an Oxor). OECD, 27. Globalisation an Regional Eonomies. Paris. 32

13 Jak E. Wahl, Uo Broll - Mitigation o Foreign Diret Investment Risk an Heging Shmit, C.W. an U. Broll, 29. Real exhange rate unertainty an U.S. oreign iret investment: An empirial analysis. Review o Worl Eonomis, 145, Shapiro, A.C., 26. Multinational Finanial Management. (John Wiley an Sons, Hoboken, NJ). Wagner, W., 27. International risk sharing an government moral hazar. Open Eonomies Review 18, Zilha, I., Charaterizing the eiient set when preerenes are stateepenent. Journal o Eonomi Theory 41,