Multinationality and Downside Risk: The Contingent Roles of Option Portfolio Characteristics and Organizational Factors

Abstract

Multinational operations confer firms a portfolio of switching options that offer the potential for operating flexibility in the context of input cost variability, allowing firms to reduce downside risk. In this paper, we argue that two conditions may shape the relationship between multinationality and downside risk suggested by real options theory. First, when subadditivity is present in a multinational firm’s option portfolio (e.g., when the firm operates affiliates predominantly in host countries with high labor cost correlations), multinationality is less likely to reduce downside risk since less valuable opportunities exist for shifting operations. Second, when a firm’s organization facilitates the coordination of cross-border activities, multinationality is more likely to reduce downside risk because the firm is better able to exploit the shifting opportunities. Analysis of a comprehensive panel dataset of Japanese manufacturing firms and their foreign manufacturing affiliates confirms that the negative impact of multinationality on downside risk is significantly stronger for firms operating in host countries with relatively low labor cost correlations. Increased control and coordination of foreign affiliates associated with greater equity stakes in the affiliates and more intensive expatriate assignment strengthen the relationship between multinationality and downside risk, in particular for those firms operating in host countries with relatively low labor cost correlations.