Exchange rate uncertainty, futures markets, and foreign direct investment

In this thesis, I consider a multinational firm (MNF) which produces and sells in domestic and foreign markets with monopolistic power in both markets. The purpose of the study is to analyze the production, hedging, and investment decisions of the firm under exchange rate uncertainty. The timing of decisions and the firm's attitude toward risk are crucial components in determining the effect of exchange rate risk. Assuming that some decisions are made under uncertainty, while other decisions are made under certainty, I examine how exchange rate uncertainty affects the firm's output decisions, and extend the study to the case when transportation costs exist. It is shown that for risk neutrality, the effect of uncertainty on total output depends upon the shape of demand curves. In the presence of transportation costs, uncertainty makes the risk neutral firm produce more in the domestic plant. Furthermore, the availability of foreign exchange futures markets encourages the risk averse firm to produce more in the domestic plant except when futures are perceived as upwardly biased, while it produces less in the domestic plant under uncertainty than under certainty in the absence of futures markets. In addition, the optimal futures position is short for linear demands and unbiased futures markets, and full hedging with futures contract only cannot be attained in this nonlinear profit model. I also study the issue of foreign direct investment. I consider a model in which the MNF may open only the home plant or may open the home and foreign plants, its choice depending on which case yields higher expected profits. If total output is price responsive, the risk neutral firm is more likely to open the foreign plant than in the case of fixed total output. In the case that the MNF faces a competitor in the foreign market, if the MNF does not open the foreign plant, both firms benefit from risk. However, risk raises the value of opening the foreign plant, and thus induces the MNF to open it, reducing the expected profit of the local firm under uncertainty.