foad_05

Emory University
Department of Economics
Working Papers

Title: Currency Unions, Options, and Foreign Direct Investment

Number: 05-16

Author: Hisham Foad

Issue Date: April 2005

Abstract: A multinational deciding on where to locate a foreign production facility may not
be indifferent to the choice of location. Numerous variables such as production costs,
market access, and local tax treatments will influence the decision as to where the plant is
located. Another key variable in this decision is uncertainty. Following the work of
Dixit, a firm has an option to make a risky investment, and if this investment is at least
partially irreversible, the option has some positive value. As the uncertainty in the
investment project increases, so too does the value of the option. When comparing two
investment projects that are identical in all respects except their underlying profit
volatility, the one with the greater degree of uncertainty will require a higher trigger level
of profits to be exercised. This paper examines the impact of uncertainty in exchange
rates on a multinational.s decision to locate within or outside a currency union. The
option values and trigger levels of investment within and outside the union are derived as
a function of exchange rate variances and correlations, transport costs, and market size.

Title:	Currency Unions, Options, and Foreign Direct Investment
Number:	05-16
Author:	Hisham Foad
Issue Date:	April 2005
Abstract:	A multinational deciding on where to locate a foreign production facility may not be indifferent to the choice of location. Numerous variables such as production costs, market access, and local tax treatments will influence the decision as to where the plant is located. Another key variable in this decision is uncertainty. Following the work of Dixit, a firm has an option to make a risky investment, and if this investment is at least partially irreversible, the option has some positive value. As the uncertainty in the investment project increases, so too does the value of the option. When comparing two investment projects that are identical in all respects except their underlying profit volatility, the one with the greater degree of uncertainty will require a higher trigger level of profits to be exercised. This paper examines the impact of uncertainty in exchange rates on a multinational.s decision to locate within or outside a currency union. The option values and trigger levels of investment within and outside the union are derived as a function of exchange rate variances and correlations, transport costs, and market size.

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