This paper extends the decision problem of a multinational regarding how much to invest abroad optimally under uncertainties stemmed from the exchange rate movements, with the presence of a correlated background risk, in a two moment decision model. This framework is based upon the utility from the expected value and the standard deviation of the uncertain random total profit of the multinational firm. This modelling approach allows us to explore not only how much a risk averse investor optimally invests abroad when facing uncertainties regarding the exchange rate movements; but also to discover how does (and under what conditions) any perturbation in the background risk (which is linearly related to the endogenous exchange rate risks) affect the optimal foreign investment decision for a risk averse investor. All comparative static effects are described in terms of the relative sensitivity of the investor towards risk. This simplest possible analytical framework is useful for explicit empirical estimation of risk aversion elasticities in the literature of multinational firm and FDI decision.
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Udo Broll and Soumyatanu Mukherjee
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