International Firm Investment under Exchange Rate Uncertainty*

Abstract

This article develops a real options theory to examine the effects of exchange rate uncertainty on foreign direct investment. Firms face a choice between participating in foreign markets through exports or investing abroad to relocate production. The model predicts that the most productive firms invest abroad when exchange rate volatility is low and export otherwise, whereas the least productive firms invest abroad when volatility is high. Aggregation over heterogeneous firms produces a negative and nonlinear relation between exchange rate uncertainty and total international investment. An analysis of eighty-four developed and emerging economies over the 1996–2012 period provides empirical support for the model’s predictions.