Multinational firm, exchange rate risk and the impact of regret on trade

Udo Broll, Peter Welzel () and Kit Pong Wong

No 04/14, Dresden Discussion Paper Series in Economics from Technische Universität Dresden, Faculty of Business and Economics, Department of Economics

Abstract: This paper examines the behavior of the regret-averse multinational firm under exchange rate uncertainty. The multinational firm simultaneously sells in the home market and exports to a foreign country. We characterize the multinational firm's regret-averse preferences by a modified utility function that includes disutility from having chosen ex-post suboptimal alternatives. The extent of regret depends on the difference between the actual home currency profit and the maximum home currency profit attained by making the optimal production and export decisions had the multinational firm observed the true realization of the random spot exchange rate. We show that the conventional results that the multinational firm optimally produces less, sells more domestically, and export less abroad under uncertainty than under certainty holds if the multinational firm is not too regret averse. Using a simple binary model wherein the random spot exchange rate can take on either a low value or a high value with positive probability, we show that the multinational firm may optimally produce more, sell less domestically, and export more abroad under uncertainty than under certainty, particularly when the multinational firm is sufficiently regret averse and the low spot exchange rate is very likely to prevail.This note examines the behavior of a competitive firm that faces joint price and inflation risk. Given that the price risk is negatively correlated with the inflation risk in the sense of expectation dependence, the firm optimally opts for an overhedge if the firm's coefficient of relative risk aversion is everywhere no greater than unity. Furthermore, banning the firm from forward trading may induce the firm to produce more or less, depending on whether the price risk premium is positive or negative, respectively. While the price risk premium is unambiguously negative in the absence of the inflation risk, it is not the case when the inflation risk prevails. In contrast to the conventional wisdom, forward hedging needs not always promote production should firms take in inflation seriously.

Keywords: Exchange rate uncertainty; Multinational firms; Regret theory (search for similar items in EconPapers)
JEL-codes: D81 F23 F31 (search for similar items in EconPapers)
Date: 2014
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Persistent link: https://EconPapers.repec.org/RePEc:zbw:tuddps:0414

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