Exchange Rate Risk and Two-Way Foreign Direct Investment

Jie Qin

International Journal of Finance & Economics, 2000, vol. 5, issue 3, 221-31

Abstract: Modern theory of foreign direct investment (FDI) identifies market frictions such as transport costs and tariffs as major obstacles to a firm's access to foreign markets and as important reasons for two-way FDI. An alternative rationale for two-way FDI is offered in the present paper from a theoretical examination of the relation between exchange rate risk and FDI. In a one sector two-country model, it is assumed that producers decide both the domestic and the foreign production capacities so as to maximize the utility function based on rates of return and real exchange rates. It is shown that two-way FDI occurs when deviations from the purchasing power parity are not significant. The higher the exchange rate volatility, the larger the ratio of FDI to export. Two-way FDI reduces the producers' exchange rate risk; under certain conditions, this reduction of exchange rate risk is a driving force for two-way FDI. Copyright @ 2000 by John Wiley & Sons, Ltd. All rights reserved.

Date: 2000
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