Foreign Direct Investment and Exchange Rate Volatility: a Non-Linear Story

This paper sheds light on the influence of exchange rate volatility on foreign direct investment (FDI), both at the theoretical and the empirical level. The novelty of the empirical analysis, which is based on a panel of 27 OECD countries over the period 1982-2002, is to provide evidence of a U-shaped relation between observed FDI flows and exchange rate volatility: the effct is negative for low levels of uncertainty and positive for higher levels. I also construct a real-options theory of a multinational, which contemplates FDI to relocate production abroad under a stochastic exchange rate. The model provides a theoretical rationale for this findingand offers new insights in the investment-uncertainty relation. Both the predictions and the theoretical approach stand in stark contrast to the real-options literature, which implies a negative relation. Previous studies analyze the option value of investing in a single project and limit their predictions to the current investment level. In contrast, I derive the expected foreigndirect investment of an economy over a given time period. To estimate this value, I assume that all exporting firms are proposed a different offshoring project, ranging from loss-making to very profitable. For each firm, I compute the probability of investing abroad over the desired time period. Eventually, I investigate the influence of exchange rate volatility on the expected investment level. The paper therefore extends the real-options literature and proposes a new framework to analyze the dynamics of aggregate investment.