Currency Unions, Options, and Foreign Direct Investment

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. Simulations provide insights into the relative values of these variables that induce investment within or outside the currency union. The model is then calibrated to fit exchange rate data for the UK, Germany, and France. Under these estimates, a multinational would prefer to invest within the EMU even if the UK market were three times the size of the EMU combined markets. Such a striking result is supported by the empirical observation that the UK's share of FDI inflows to the European Union has drastically declined since the introduction of the euro in 1999.the euro in 1999