International Review of Economics and Finance 11 (2002) 207 227

Foreign exchange rates and the corporate choice of foreign entry mode
H. Young Baeka,b,*, Chuck C.Y. Kwokc
College of Business Administration, University of Texas-Pan American, 1201 W. University Drive, Edinburg, TX 78539, USA b Wayne Huizenga Graduate School of Business and Entrepreneurship, Nova SW University, 3100 Southwest 9th Avenue, Fort Lauderdale, FL 3331RR5, USA c Moore School of Business, University of South Carolina, 1705 College Street, Columbia, SC 29208, USA Received 30 October 2000; received in revised form 27 February 2001; accepted 2 April 2001
a

Abstract This study is the first attempt at examining the effects of foreign exchange (FX) rate and volatility on the corporate choice of foreign entry mode and shareholder wealth. For all worldwide US-related foreign direct investments (FDIs) announcements in 1995, we find evidence that, on average, a stronger home currency is related to a higher propensity to choose a subsidiary and that the change in shareholder wealth around subsidiary announcements is greater when the home currency is stronger for non-US parents. On the effects of host currency volatility, the data support the flexibility option (international diversification) hypothesis for the US (non-US) parents. D 2002 Elsevier Science Inc. All rights reserved.
JEL classification: F21; F23; F31 Keywords: Foreign exchange; Volatility; Foreign direct investment; Diversification; Flexibility option

* Corresponding author. Tel.: +1-954-262-5103; fax: +1-425-955-4025. E-mail address: hybaek@yahoo.com (H.Y. Baek). 1059-0560/02/$ see front matter D 2002 Elsevier Science Inc. All rights reserved. PII: S 1 0 5 9 - 0 5 6 0 ( 0 1 ) 0 0 1 0 6 - X

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1. Introduction This study is the first attempt at examining the effects of foreign exchange (FX) rate level and volatility on the corporate-level choice of foreign entry mode and shareholder wealth. Thus far, studies on how FX affects foreign direct investments (FDIs) are mostly done at the macro level. Among the authors who have studied the effect of currency strength on the level of FDI between two national economies, Bell and Campa (1997), Blonigen (1997), Froot and Stein (1991), and Kogut and Chang (1996) have observed that the real value of the home currency is positively related to the level of direct investment in the host country. In a similar vein, Crutchley, Guo, and Hansen (1991) and Ojah, Seitz, and Rawashdeh (1997) report that the parent shareholders wealth gains around FDI announcements are significantly positive only when the home currency is stronger than in the past. The effect of host currency volatility on the FDI level and on international trade has also been documented only at the country level. Franke (1991) and Roy and Viaene (1998) argue a positive relationship between host currency volatility and the volume of trade, and between volatility and vertical FDI, respectively. Bell and Campa (1997), however, find that FX volatility is negatively related to the net investment in a host country. The current study is motivated by three streams of literature. The first stream of related literature examines how FX affects FDI. As mentioned above, these studies are mainly conducted at the macroeconomic level. While such studies provide some guidance to national trade policymakers and FX administrators, they shed little light on the corporate responses to the changes in currency values. Financial managers of multinational corporations (MNCs) can only make indirect inferences. The focus of the present study is at the micro level, examining how the corporate choice of foreign entry modes is affected by FX behavior. The second stream of literature consists of studies conducted by international business scholars (e.g., Agarwal & Ramaswamy, 1992; Hennart & Reddy, 1997 and so forth). They have discussed why joint ventures (JVs) and subsidiaries are chosen as modes of foreign entry. While other factors are mentioned, the role played by FX behavior in such choice has not been adequately examined. The third stream of literature consists of some recent studies (e.g., Kwok & Reeb, 2000) that report distinct corporate behavioral patterns across MNCs of different countries. In short, results obtained from US MNC data may not be generalized to all MNCs around the world. The present study will examine the sample of both inbound and outbound US-related FDIs to see if the results are different between US and non-US MNCs. The present study, drawing upon these three lines of literature, is the first attempt at examining the effect of home currency strength and host currency volatility on the corporatelevel choice between a subsidiary and a JV as a foreign entry mode, and on the parent shareholders wealth changes. Specifically, this study examines two competing hypotheses on why firms invest overseas: international diversification versus flexibility option effects. The authors formulate mathematical models to theoretically predict the impact of a stronger currency and a more volatile currency, respectively. To empirically test the models, the authors use the data of inbound and outbound US corporate FDIs in 1995. We find evidence from the sample of non-US firms that, on average,

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a stronger home currency is related to a higher propensity to choose a subsidiary and that subsidiary choosing shareholders wealth increase is greater when the home currency is strong than when it is weak. We also find that host currency volatility acts differently with US firms and non-US firms. The sample of US firms seems to favor the flexibility option hypothesis, while the non-US sample favors the international diversification hypothesis. In the next section, we will survey the literature on the FX rate and FDI, and develop hypotheses on the effects of FX level on the foreign entry mode choice. In Section 3, we will review previous studies on FX volatility and FDI, and develop the competing hypotheses on the effects of FX volatility on the entry mode choice: the international diversification hypothesis versus the flexibility option hypothesis. We will present data and methodology in Section 4, and the test results in Section 5. A Discussion section will conclude this study.

2. FX rate and FDIs Previous studies have examined the effect of FX rate only at the aggregate level of FDI. They suggest that a stronger home currency leads to a higher level of aggregate FDI and an increase in the wealth of the target and acquirers shareholders around FDI announcements. Froot and Stein (1991) argue that, in an imperfect market, firms that visit credit markets have to pay higher cost of capital rates because credit institutions pass the monitoring costs to the borrowers. Firms investing in an appreciating currency can finance internally and reduce the cost of capital. If FX rates deviate from the purchasing power parity (PPP) rate at least in the short run, a stronger home currency would encourage firms to invest in the host country. Froot and Stein predict that the overall FDI level from a country will increase when the home currency is stronger than a PPP-compatible rate, and find that the change in foreign assets in the US has a negative relationship with the real value of the US dollar during the 19731988 period. The negative relationship seems to be more prominent in the industries with a higher level of potential information asymmetry (e.g., chemical and machinery industries). Kogut and Chang (1996) find for 95 Japanese firms in the Tokyo Stock Exchange (TSE) electronics industry that a real appreciation of the Japanese yen leads to more entries into the US during the 19761989 period. Blonigen (1997) also reports for the 19751992 period that the real exchange rate between the Japanese yen and the US dollar has a positive relationship with the number of Japanese acquisitions in the US, especially in the manufacturing industries with more firm-specific assets (proxied by research and development expenditures). Consistent with the above studies is Bell and Campas (1997) observation that the level of chemical product investments in European Union countries by US companies is negatively related to the average level of the IMF trade-weighted exchange rate index for the host country during the 19771989 period. Harris and Ravenscraft (1991) study the wealth effect of the shareholders of the targets of foreign and US buyers. Shareholders of the targets of foreign buyers experience significantly higher wealth gains than targets of US firms, and target shareholders wealth gains are higher when the buyers currency is stronger than its 17-year average. Crutchley et al. (1991) find for JapaneseUS JVs that shareholder wealth gains are significantly positive only for the firms

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that announced JV formation when their home currency is stronger. Ojah et al. (1997) report that the shareholders of US firms that announce offshore JVs experience a significantly positive (negative) wealth effect when dollar in the previous year is stronger (weaker) than the average during the 19811990 period. Froot and Stein (1991) also report that the sensitivity of the number and dollar-amount of FDI to the real exchange rate is greater for mergers and acquisitions than for the JV.1 Since a stronger home currency requires less capital outlay for a fixed investment in local currency, some firms that were previously discouraged from a subsidiary investment due to capital rationing would be able to afford a wholly owned subsidiary when their home currencies become stronger, cet par. 2.1. A model To further analyze, let us suppose a US-based firm that needs to decide the investment amount and share ownership in two potential foreign projects. Let X, X1, and X2 be one plus the rate of return in local currencies for domestic, the first, and the second foreign projects, respectively. We assume that all the projects have the same initial capital outlay and the same expected rate of return in local currency. EX EX1 EX2 1

Let p (0 < p < 1) denote the fraction of total capital invested in foreign projects, and let a and (1a) denote the percentage ownership in Projects 1 and 2, respectively.2 Since Projects 1 and 2 are the same in initial investment and return, the sum of share ownership in Projects 1 and 2 is 100%. R, the total rate of return to the US firm at the end of the period will be (Eq. (2)): R 1 pX pa X1 f1 p1 aX2 f2 , 2

where fj denotes one plus the appreciation rate for currency j during the period. If the covariance between local-currency return and the currency appreciation rate is zero, the expected total return to the firm will be: ER 1 pEX pa EX E f 1 p1 aEX E f2 EX 1 p pa E f1 p1 aE f2 3

Suppose that f1 and f2 are binomial variables. f1 will take the value of f h with the probability of q1, and f l with (1q1) probability. f2 will take f h with the probability of q2 and
1 The coefficients from the regression of the dollar FDI level on the real exchange rate with other controlling variables are 0.057 for the mergers and acquisition data and 0.0056 for the JV data. The coefficients from the similar regression with the number of FDIs as a dependent variable are 1.8996 for mergers and acquisitions and 0.2422 for JVs. All coefficients are statistically significant. 2 (1 p) + p* a + p*(1 a) = 100%.

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f l with (1q2) probability ( f l<1<f h). qi is a monotonic function of the ith currencys deviation from PPP-rate. When the current exchange rate is PPP-equivalent, qi will be 0.5. As a currency is more devalued relative to PPP-rate, qi will become higher. When the Foreign Currency 1 is more devalued against the PPP-rate than the Foreign Currency 2, q1 will be greater than q2.3 Eq. (3) can be rewritten as Eq. (4).  n o n o ER EX 1 p pa q1 f h 1 q1 f l p1 a q2 f h 1 q2 f l 4 2.2. Comparative statics analyses Suppose Currency 1 is more devalued from its PPP-rate than Currency 2 (i.e., q1 > q2). Since E[R] is a function of p( q1,q2), a( q1,q2), q1 and q2, comparative static analyses are obtained in Eqs. (5)(8). Epq1 Eaa Epa Eaq1 @p pq1 q2 f h f l 2 p >0 2 h 2 @q1 q1 q2 Epp Eaa Epa Eap q1 q2 f f l @p p >0 @q2 q1 q2 @a aq1 q2 f h f l 2 a >0 2 h l 2 @q1 q1 q2 q1 q2 f f @a 1a <0 @q2 q1 q2 5 6

7 8

Ejk represents the partial of @E/@j over partial k. Eqs. (5) and (6) predict that, regardless of a currencys degree of devaluation from its PPP-rate, a little more deviation from PPP-rate (i.e., a small increase in q1 or q2) would lead to an increase in overall foreign investment ( p). When Currency 1 is devalued relative to the PPP-rate to a more degree and its probability to appreciate later is higher than Currency 2, a small increase in q1 would lead to an increase in a, i.e., a higher share ownership in an affiliated firm in Country 1. A small depreciation of the Currency 2 would lead to a decrease in a, i.e., less investment in the Country 1 affiliate and more share ownership in Country 2 affiliate. 2.3. Hypotheses If the US firms objective is to maximize its expected total return and if the local-currency rate of return is independent of the currency exchange rate, the MNC would increase the overall level of foreign investment ( p) and especially the affiliation share ownership in a
3 The short-run exchange rate deviations from and long-run reversion to PPP-rates are widely accepted in the theoretical and empirical literature. See, for example, Kim (1990).

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country whose currency is further devalued. The firms that maximize their expected returns would increase a (share ownership in Country 1 affiliates) and would be more likely to choose a subsidiary form in the host country whose currency becomes weaker. From these arguments, we propose the following hypotheses. Hypothesis 1: Firms with a host currency that has weakened are more likely to choose a subsidiary over a JV as a mode of foreign entry than firms with a stronger host currency, ceteris paribus. Hypothesis 2: Shareholder wealth change around foreign entry announcements will be greater when firms with a weaker host currency choose a subsidiary over a JV, ceteris paribus.

3. FX volatility and FDIs International business textbooks often list international diversification and reaction to FX rate movements as the motives for FDI (Madura, 2000, pp. 365372). Since competitive advantages in market demand, technology, access to raw materials, etc., have no immediate relationship with FX rate movements, this study focuses on the benefits of international diversification and flexibility option. For firms with international activities, an increase in exchange rate volatility would lead to an increase in profit variability. If exporters are risk-averse and FX hedging is costly, an increase in FX volatility will reduce the volume of international trade.4 Risk reduction through international diversification seems to affect corporate decisions, as Bell and Campa (1997) find that exchange rate volatility measured as the standard deviation of the monthly change in the log of the exchange rate index for the host currency is negatively related to the net investment in chemical products in European Union countries by US companies during the 19771989 period. On the other hand, Roy and Viaene (1998) argue that an increase in FX volatility may have a positive effect on the level of vertical FDI, and find in a simulation study that an oligopolistic firm with a choice between FDI and importing would be more likely to choose FDI when exchange rates are more volatile. Kogut (1996) and Kogut and Kulatilaka (1994) argue that a flexibility option is the true source of the increased value of being multinational, although exercise may be difficult due to organizational features. They contend that, neglecting transportation and factor cost differentials, firms need to choose a plant location in a country where the FX rate is the most volatile. When the exchange rate is more volatile, exercise of an operating flexibility option is more likely and the option would be more valuable. For the period of 19771993, Rangan (1998) finds that MNCs shift production among globally

4 Franke (1991) concisely summarizes the early papers on foreign exchange volatility and international trade by Baron (1976), Clark (1973), and Ethier (1973).

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located sites when FX rates change and confirms the idea that firms utilize operating flexibility. In Sections 3.1 and 3.2, we would like to build a model and formulate competing hypotheses: international diversification hypothesis versus flexibility option hypothesis. 3.1. International diversification hypothesis Under the hypothesis that one major motive of FDI is to reduce risk through investment in different countries, a very volatile host currency would discourage foreign investments to the country because the increased FX risk offsets at least some of the diversification benefits. If the level of investment for a given company is fixed and cash flows from two JV operations are less than perfectly correlated, firms investing in host countries with volatile exchange rates would prefer to split their investment into multiple JVs than to invest in a wholly owned subsidiary. Continuing the previous example of a US firm, let us suppose that two foreign currencies expected appreciation rates are the same: E f1 E f2 F: 9

Since the local-currency rates of return have the same expected values and zero covariance with exchange rates, the expected total return to the firm is derived from Eqs. (1) and (9), and is expressed in Eq. (10). ER 1 pEX pa EX F p1 aEX F EX 1 p pa F p1 aF EX 1 pF 1 10

As one can see from Eq. (10), the expected rate of return to the firm is independent of a. A comparative static analysis still suggests that an expected return-maximizing firm would increase p when F increases.5 That is, a firm maximizing its mean return would invest more in foreign countries when foreign currencies are expected to appreciate in the future (i.e., when US dollar is stronger than PPP-rate). Suppose now that the firm chooses a level of a to minimize the variance of total return as expressed in Eq. (11). For simplicity, we assume all the local-currency returns are the same and nonstochastic (X1=X2=X=X ). V R p2 a2 X s2 p2 1 a2 X s2 2p2 a1 aX r12 s1 s2 , 1 2
2 2 2

11

where sj denotes the standard deviation of fj (one plus the currency js appreciation rate), and r12 the correlation coefficient between two-currency appreciation rates. When the US firm
5

The sign of @p/@F would be equal to the sign of @ 2E[TR]/@p@F = E[X ] > 0.

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2 2 2 chooses an optimal level of a=a(s1 ,s2) to minimize the variance of total return, @a/@s1 will 2 2 take the opposite sign as @ V [R]/@a@s1 in Eq. (12).     @ 2V s2 s2 2 2 p X 2a 1 r12 r12 12 s1 s1 @a@s2 1

When a is not a small number, and s1 and s2 are similar in size, the sign of Eq. (12) is positive. A variance-minimizing firm would decrease investment in a country (a) when its currency is more volatile. As a decreases, a firm is more likely to set up a JV in the Host Country 1. The prediction from this line of analysis, labeled as the international diversification hypothesis, is that when the host currency is volatile, firms are less likely to choose a subsidiary over a JV as a mode of foreign entry. Hypothesis 3: Firms investing in a host country whose currency is relatively more volatile are more likely to choose a JV over a subsidiary as a mode of foreign entry, ceteris paribus. Hypothesis 4: Shareholder wealth change around foreign entry announcements will be greater when firms choose a JV over a subsidiary as a foreign entry mode in a host country with volatile currency, ceteris paribus. 3.2. Flexibility option hypothesis Franke (1991) views exporting as an option that is exercised if profitable, and argues that under constant competition, the value of exporting is an increasing function of FX volatility. His argument is consistent with the fact that a stock option value increases when the underlying stock return volatility increases. Assuming that the costs of the initiation and termination of exporting activities are increasing and concave for the exchange rate, Franke argues that the trade volume of a net-present-value-maximizing firm grows with exchange rate volatility. Sercu and Vanhulle (1992) also show in a model that as FX volatility increases, exporters may be better off and firms may tolerate dumping. JV partners are analogous to the multiple agents in a team. Holmstrom (1982) uses the term team as a group of individuals who are organized so that their productive inputs are related.6 As Kandel and Lazear (1992) state, partnerships are different from hierarchical organizations in that the members of the team are all residual claimants. All the multiple partners of a JV have claims to a portion of joint output. Holmstrom argues in his Theorem 1 that, unlike the single-agent case, free-riding problems may occur in multiple-agent cases even when the output function is not stochastic. A shirking agent cannot be identified when the joint output is the only observable indicator of inputs. Given the other partners free-riding and moral hazard problems faced by a JV partner, exercises of a flexibility option from the viewpoint of a single JV partner may not be optimal. Since the exercise decision by a JV partner may not be optimal for all the partners and the
6 Each team player puts in its own effort, all the inputs jointly determine the output, and the payoff to an agent depends on the joint output.

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flexibility option of a JV may expire earlier than that of a subsidiary, a flexibility option in a JV would be less valuable to a parent organization that in a wholly owned foreign subsidiary. To explore this line of reasoning, we will analyze the previous example in a different way. Suppose that only when the firm chooses a subsidiary (a=1 or very close to 1), it can choose the site of production depending on the FX rate between home and the foreign country. In the presence of a flexibility option, the total rate of return to the firm (RC) is the larger of the home country rate of return and the foreign country return converted to home currency, as expressed in Eq. (13). RC maxX ,X1 f1 The expected total return is expressed in Eq. (14). ERC EX Emax1,f1 EX 1 Emax0,f1 1 EX 1 Call f1 ,1,s2 1 14 13

2 where Call(f1,1,s1 ) is the value of a European call option with f1 (1+appreciation rate) as the underlying asset price and 1 as the exercise price. It is well known that the value of a call option is a positive function of the volatility of its underlying asset. By having a wholly owned foreign subsidiary, the MNC may experience an increase in expected total return with high volatility in FX rates, while the return is immune from the downside risk of large-scale foreign currency depreciation. If the same firm chooses to have two foreign JVs, it loses the value of the call option in exchange for diversification effects. An unexpected huge drop in one foreign currency price may only be partly offset, unless the correlation between two foreign currencies is a perfect negative one. When the exchange rate is more volatile and thus the flexibility option is more valuable, return-maximizing firms would choose a subsidiary over a JV as an entry mode. Under this flexibility option hypothesis, the following hypotheses are derived as alternatives to Hypotheses 3 and 4.

Hypothesis 3A: Firms investing in a host country whose currency is relatively more volatile are more likely to choose a subsidiary over a JV as a mode of foreign entry, ceteris paribus. Hypothesis 4A: Shareholder wealth change around foreign entry announcements will be greater when firms choose a subsidiary over a JV as a foreign entry mode in a host country with volatile currency, ceteris paribus. 3.3. Competing hypotheses Readers should note that the two models presented above represent two different objective functions of the firms that want to make a FDI. The international diversification model expressed in Eqs. (9)(12) depicts a firm that attempts to minimize the variance of total returns, while the flexibility option model in Eq. (14) portrays another firm of which objective is to maximize the expected total return.

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Table 1 Stock return volatility and host currency volatility: US vs. non-US firms US firms Stock return volatility Host currency volatility Predicted FDI motivation 1.76% 2.71% To utilize flexibility options Non-US firms 1.93% 1.46% To reduce risk through international diversification T test .3074 .0027*** RS .0412** .0001***

Stock return volatility denotes the average standard deviation of daily returns for common equity during 200 trading days before FDI announcements of 110 US firms and 54 non-US firms with available data. Host currency volatility is measured as the average FXVOLAT for 139 US firms and 140 non-US firms with available data. T test and RS represent the P values for the t tests of mean difference and the nonparametric Wilcoxon Rank Sum test, respectively. ** Denotes statistical significance at the 5% level. *** Denotes statistical significance at the 1% level.

A natural question then is which firms are variance minimizers and which are expected return maximizers. Firms currently operating in a less volatile environment may attempt to maximize their expected returns without being overly restricted by concerns on additional risks resulting from FDI. Those firms main motivation for FDIs may be to utilize the options to flexibly control within their multinational network, and their behaviors may be better explained by the flexibility option model. Other firms are operating in so volatile an environment that their primary motivation for FDIs may be to reduce variance of returns through diversifying into low-risk countries. The behaviors of such firms may be better understood from the international diversification model. In Table 1, we examine the stock return volatility and host currency volatility for US and non-US firms. US firms experience lower standard deviation of stock returns during about one year before FDI announcements than non-US firms, and the difference is significant under the nonparametric Wilcoxon Rank Sum test. On the other hand, the average host currency volatility faced by non-US sample firms is significantly lower than that by US firms. Those two observations suggest the authors to predict that a primary motivation for FDIs by US firms is utilization of flexibility options, while non-US firms attempt FDIs into the US to reduce overall risk through international diversification activities.

4. Data and methodology Unlike many previous studies that limit their analyses to the FDIs between two countries,7 this study draws the initial sample firms investing in Year 1995 into or from the US from the

7 For example, Crutchley et al. (1991) examine 149 US Japan JVs during 1979 1987. Hennart and Reddy (1997) examine 428 US entries by Japanese firms during the period 1978 1989, and Harris and Ravenscraft (1991) use 159 acquisitions of US firms during 1970 1987. Alternatively, Hu and Chen (1996) examine 2434 JVs in China. Woodcock, Beamish, and Makino (1994) use 322 North American entries by Japanese firms in 1992. Agarwal and Ramaswamy (1992) surveys US firms that were leasing in 1986.

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company news section of the LexisNexis Academic Universe. The initial sample includes 182 parent organizations. Accounting information for the period 19901994, and stock return data for 200 trading days prior to and 10 trading days after the announcement are available from Standard and Poors COMPUSTAT, Center for Researches in Security Prices (CRSP) and Datastream databases. We exclude the abnormal returns (AR) for the parents with a concurrent firm-specific event for five trading days before and after the announcement. Supplemental sources of information for foreign-based companies include Compact Disclosure and WorldScope. Descriptive statistics on the variables are given in Table 2. Among the 182 parents that announced an FDI in 1995, 115 are US firms and 67 are foreign ones. One hundred thirty firms
Table 2 Descriptive statistics Variable GFIELD SUBS Variable RSHARE FXSTRONG FXVOLAT HOSTSIZE RELSIZEa FSR FCFRATIO RDRATIO BLOCKO INSTO Parent regions Affiliate regions N 182 182 N 179 179 179 182 116 115 132 94 133 117 USA (115) USA (32) 1 130 34 Min 0% 0.244 0 162 0 0% 2.523 0 0% 0% Europe (35) Europe (47) 0 52 148 Med 50% 1.00 2.65% 2447 0.0182 28.9% 0.088 0.012 20.2% 49.8% Asia (28) Asia (77) Max 100% 4.6091 18.04% 40,813 5.1836b 100%c 0.548 0.222 100% 97.6% Latin America (4) Latin America (26) Mean 52.68% 1.2996 3.23% 11,843 0.1938 29.85% 0.069 0.033 26.35% 48.06% S.D. 28.47% 0.8514 3.90% 11,631 0.6040 26.74% 0.305 0.044 25.65% 21.30%

GFIELD takes the value of 1 if a parent announces that it will build a foreign affiliate, and 0 if it announces that it will purchase an existing business. RSHARE denotes an investing firms relative share ownership in its affiliate under the assumption that any option to buy or sell more shares is fully exercised, and SUBS takes the value of 1 if RSHARE is greater than 95%. FXSTRONG is the ratio of the announcement-year average exchange rate of the host currency per ith parents currency over the average rate for the previous 3 years. FXVOLAT measures the standard deviation of monthly changes in exchange rates of the host currency relative to the home currency unit for 3 years prior to announcement. HOSTSIZE denotes the host country GDP in 1994 in million of US dollars. RELSIZE refers to the ratio of total investment in the affiliate over total assets of the parent firm at the fiscal year-end prior to the announcement. FSR is the ratio of the parents foreign sales over total sales during the previous fiscal year. FCFRATIO denotes the ratio of free cash flow over total assets, and RDRATIO the ratio of R&D expenditure over total assets. BLOCKO denotes the firms common equity held by shareholders with at least 5% ownership, and INSTO the institutional ownership. a The median and mean of the parent firms total asset are 12,493 and 43,797.5 million US$, respectively. The median and mean of the affiliates total investment are 200 and 627.87 million US$, respectively. The median and mean investments in an affiliate by a parent firm are 80 and 332.12 million US$, respectively. b This affiliate size is five times that of the parent, which is a minority partner of a large JV. c For one parent, all sales are foreign originated.

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(71.4%) announced plans to start a green-field operation (GFIELD), while 52 firms announced plans to purchase an existing foreign operation. RSHARE denotes an investing firms relative share ownership in its affiliate under the assumption that any option to buy or sell additional shares is fully exercised, and SUBS (subsidiary) takes the value of one if a relative ownership is greater than 95%. Only 34 firms chose to have a wholly owned subsidiary. The majority (148 firms; 81.3%) chose to have an international JV (IJV) as an entry mode. A median share ownership in an affiliate is 50% and the mean value is 52.68%. FXSTRONG represents the strength of the parent firms home currency in terms of host currency. Following Ojah et al. (1997), we assign the ratio of the average announcement-year exchange rate over the average for the previous 3 years. FXSTRONG variable has a median value of 1, and a mean of 1.2996. On average, the home currency in 1995 was about 30% stronger than the past 3 years average. FXVOLAT is a host currency volatility measure, proxied by the standard deviation of monthly changes in host currency value relative to a home currency unit for 3 years prior to the announcement. FXVOLAT ranges from 0% to 18.04% with a mean of 3.23% and a median of 2.65%. To control for the other factors that may affect the entry-mode decision and shareholder wealth, we select some variables examined in the literature. HOSTSIZE denotes the investing firms host country gross domestic product (GDP) per capita in 1994, and has a median of US$2447 and a mean of US$11,843. RELSIZE refers to the relative size of an affiliate, computed as the ratio of total investment in the affiliate over total assets of the parent firm at the fiscal year-end prior to announcement. Although the average affiliate size is 19% of the parents total asset, the median size is only 1.8%. FSR, the ratio of the parents foreign sales over total sales during the previous fiscal year, represents the parent firms international experience. The foreign sales ratio ranges from 0% to 100%, and has a mean and median of about 29%. Corporate managers may make decisions that are suboptimal from their shareholders point of view, and efficient stock markets react unfavorably to the announcements made by those firms. The degree of agency problems between shareholders and managers can be estimated in different ways. In this paper, we follow Prowses (1990) research and development expenditure ratio (RDRATIO) and Jensens (1986) free cash flow ratio (FCFRATIO) as the proxies of potential principalagent problems.8 FCFRATIO denotes the cash flow in excess of that required to fund all projects that have positive net present values. A high FCFRATIO value suggests that a large amount of cash is under managers discretion and may be abused, and a high RDRATIO value may represent the difficulty of shareholders monitoring. The sample firms free cash flows range from 2.52 times to 0.55 times the sales, while its mean and median are close to 7%. RDRATIO has an average of 3.3% and a median of 1.2%. One way to reduce potential agency conflicts and suboptimal decisions is monitoring by the active shareholders. In search of the proxy variables for the shareholder activism, we follow the arguments of Shleifer and Vishny (1986) on the role of block shareholders and of
8 RDRATIO = research and development expenses/sales; FCFRATIO=(operating income + depreciation expenses interest expenses taxes dividends)/sales.

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Pound (1988) on the role of institutional owners as active monitors. Following a typical agency relationship and ownership study like McConnell and Servaes (1990), we use percentage equity ownership held by block shareholders of 5% or more shares (BLOCKO), and that by the institutional investors (INSTO).9 A high value of block ownership or institutional ownership represents an active monitoring from large and/or informed shareholders that may reduce the suboptimal decisions by managers. Block ownership has a median of 20.2% and a mean of 26.4%, while the mean (48%) and median (50%) of institutional ownership are much higher.

5. Empirical findings Following Brown and Warner (1985) and Ojah et al. (1997), we employ an event study methodology to assess the effects of foreign equity investment announcements on the wealth of the parent-firm shareholders. Since firms often release news during the nontrading hours, we calculate cumulative abnormal return (CAR) of the investing firms common share on the day of the news appearance on an electronic wire service (t =1) and the next trading day (t = 0) to capture the reactions from stock markets in different time zones.10 Table 3 shows the results from the tests of CAR difference between two groups divided by each independent variable. A significantly higher CAR reflects that the stock markets reaction to the announcements of a foreign entry is more favorable. For the whole sample, CAR to the acquiring shareholders is 0.34% and is statistically insignificant.11 For the nonUS sample, firms with a stronger home currency experience a significantly higher average CAR by 2.16%. Among the parents that chose subsidiaries, those with a stronger home currency experience a higher CAR than those with weaker home currency by a statistically significant 2.11%. When home currencies are weaker, the average CAR for the firms that chose a subsidiary is significantly lower than that for the firms that chose a JV (2.01% vs. 0.55%). The univariate test results suggest that shareholder wealth changes are greater when firms choose subsidiaries under a stronger home currency, and support Hypothesis 2. It is interesting, however, that only the non-US shareholders experience significant CAR difference, and those results direct the whole sample results. Host currency volatility seems to lead to no difference in CAR for the combined sample of all parents. For all the parents of subsidiaries, firms with more volatile host currencies experience a significantly lower average CAR than others (1.83% vs. 0.08%). For the

Institutional ownership denotes the percentage of common shares owned by institutional investors, and block ownership the percentage of common shares owned by the shareholders of 5% or more shares. 10 Suppose the news of a JV agreement between a Japanese firm and a US partner was released in Tokyo at 6:00 p.m. on a Thursday. Since 6:00 p.m. in Tokyo corresponds to 4:00 a.m. in New York on the same day, the announcement could affect the trading on the TSE on Friday (t = 0), and that on the New York Stock Exchange on Thursday (t = 1). 11 In a study of the US international acquisitions, Markides and Ittner (1994) reported a 2.07% CAR during Days 1 to + 3, and a positive relationship between dollar strength and CAR.

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Table 3 Tests of mean differences of CARs around FDI announcements SUBS and JVs Sample Panel A: Home currency All Stronger Weaker Difference US Stronger Weaker Difference Non-US Stronger Weaker Difference Panel B: Host currency All More volatile Less volatile Difference US More volatile Less volatile Difference Non-US More volatile Less volatile Difference N 57 58 43 42 15 15 CAR (%) 0.35 0.01 0.36 0.30 0.51 0.19 0.56 1.60*** 2.16*** SUBS only N 12 12 7 7 6 4 CAR (%) 0.10 2.01*** 2.11*** 0.60 0.30 0.9 0.52 5.98*** 6.5*** JVs only N 46 45 36 35 10 10 CAR (%) 0.39 0.55 0.16 0.47 0.55 0.08 0.35 0.17 0.18 SUB JV Diff. (%) 0.29 2.56*** 1.07 0.25 0.17 6.15***

60 55 46 39 15 15

0.24 0.10 0.14 0.78** 0.01 0.79** 1.49*** 0.45 1.94***

12 12 7 7 5 5

1.83*** 0.08 1.75*** 0.94 1.24* 2.18** 5.70*** 1.55 7.25***

48 43 39 32 9 11

0.75*** 0.15 0.60* 0.75** 0.26 0.49 0.78 0.17 0.95*

2.58*** 0.23 0.19 1.50** 6.48*** 1.72*

Panel C: Affiliate relative size All Higher 43 Lower 43 Difference US Higher 30 Lower 29 Difference Non-US Higher 14 Lower 13 Difference Panel D: Host country size All Higher Lower Difference US Higher Lower Difference Non-US Irrelevant

0.05 0.16 0.11 0.75 0.05 0.70 1.69*** 0.54 2.23***

12 11 6 7 5 5

1.36*** 0.25 1.11** 0.43 0.12 0.55 4.77*** 0.61 5.38***

31 32 23 23 9 8

0.86* 0.05 0.81 0.99* 0.06 0.93 0.34 0.13 0.21

2.22*** 0.30 0.56 0.18 5.11*** 0.48

58 58 44 41

0.08 0.40 0.48* 0.27 0.58 0.31

12 12 7 7

0.91*** 0.99 0.08 0.20 0.50 0.70

46 46 36 35

0.22 0.68* 0.46 0.26 0.80* 0.54

1.13*** 1.67** 0.06 1.30**

Panel E: Foreign sales ratio All Higher 49 Lower 49

0.42* 0.32

10 11

2.47*** 0.75

38 39

0.01 0.71

2.48*** 1.46*

H.Y. Baek, C.C.Y. Kwok / International Review of Economics and Finance 11 (2002) 207227 Table 3 (continued ) SUBS and JVs Sample US Difference Higher Lower Difference Higher Lower Difference N 36 37 12 13 CAR (%) 0.74** 0.22 0.37 0.15 0.29 2.52*** 2.81*** SUBS only N 6 6 4 5 CAR (%) 1.72*** 0.13 0.94 0.81 0.28 5.52*** 5.80*** JVs only N 31 30 8 8 CAR (%) 0.70 0.31 0.64 0.33 0.45 0.69 1.14**

221

SUB JV Diff. (%) 0.44 1.58* 0.17 4.83***

Non-US

Panel F: Free cash flow ratio All Higher 56 Lower 57 Difference US Higher 41 Lower 42 Difference Non-US Higher 15 Lower 15 Difference

0.20* 0.29 0.49*** 0.22 0.44 0.22 1.60*** 0.09 1.69***

11 11 6 7 5 4

3.04*** 0.29 2.75*** 1.22 0.42 0.80 5.23*** 0.08 5.15***

45 46 36 34 10 11

0.48 0.44 0.04 0.28 0.81* 0.53 0.35 0.04 0.31

3.52*** 0.73 1.50** 1.23** 5.58** * 0.12

Panel G: Block ownership All Higher 53 0.80 11 0.43 42 0.94* 0.51 Lower 54 0.32 11 1.14 43 0.16 0.98 Difference 1.12* 1.57** 1.10** US Higher 42 0.83 7 0.34 34 1.09* 0.75 Lower 40 0.02 7 0.64 34 0.02 0.62 Difference 0.85 0.98 1.11* Non-US Higher 13 0.91 4 1.63 9 0.60 1.03 Lower 12 1.78** 4 3.06** 8 1.15 1.91* Difference 2.69*** 4.69*** 1.75 This table presents the results of the tests to see if the average CAR around FDI announcements are different between two groups. N denotes the number of observation in a group, CAR the average ( 1,0) CAR for a group, and Diff. the difference in CAR between two groups. Since the results for RDRATIO are qualitatively the same as FCFRATIO, and those for INSTO are the same as BLOCKO, we only provide results for FCFRATIO and BLOCKO. Shareholders of 79 parent firms that made announcements to make green-field affiliates experience the CAR of 0.49%, which is significantly greater than that of 0.55% for 37 parents that announce to merge or acquire an existing operation. Shareholders of the US and non-US parents experience the similar wealth effects. * Denotes the statistical significance at the 10% level. ** Denotes statistical significance at the 5% level. *** Denotes statistical significance at the 1% level.

parents of IJVs, the average CAR is higher when host currencies are more volatile. These results seem to support the diversification Hypothesis 4. When we divide the sample by parent country and entry mode, both hypotheses receive some mixed support from the data. For the US parents, more volatile host currencies lead to a

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significantly higher average CAR around FDI announcements than less volatile ones (0.78% vs. 0.01%). Under a less volatile host currency, shareholders of the US parents experience a significantly lower CAR when subsidiaries are announced than when JVs are. For the US parents of subsidiaries, CAR is greater when host currency is more volatile. It seems that the shareholders of US corporations experience wealth increases when firms make a decision that increases the value of a flexibility option and the US sample supports the flexibility option Hypothesis 4A. For the sample of non-US parents, however, the relationship between host currency volatility and CAR is quite different. For the non-US parents of subsidiaries, more volatile host currencies seem to lead to a negative and significantly lower average CAR than less volatile host currencies. Non-US parents of IJVs, however, experience a significantly higher average CAR when host currencies are more volatile. When host currencies are more (less) volatile, the average CAR for the non-US parents of IJVs is significantly greater (lower) than that of subsidiaries. Shareholders of non-US firms seem to experience wealth increases when firms make a decision that diversifies their risks globally. The international diversification hypothesis, Hypothesis 4, is supported for the non-US sample. Regarding the results of the control variables, a negative relationship between the relative size of an affiliate and the shareholders wealth seems to exist only for the non-US parents, and derives the same relationship for the whole sample. Non-US parents with a higher foreign sales ratio seem to experience a significantly higher average CAR around FDI announcements than those with a lower FSR. Shareholders of non-US parents seem to gain more wealth when firms have more foreign experience, while those of US parents do not. Alternatively, agency proxies and active ownership variables show a universal pattern of shareholder wealth change across samples. Average CAR to the shareholders of the parents with a higher FCFRATIO is significantly negative and significantly lower than that with a lower FCFRATIO. Stock markets seem to react negatively to FDI announcements from firms with high potential agency costs. Negative reaction is prominent to the announcements of foreign subsidiaries, which are more subject to the managers abuse of free cash flows unlike the foreign JVs that have at least one monitoring partner. Parents with a higher block ownership consistently experience a higher average CAR than those with a lower block ownership, and in many cases, the difference is statistically significant. The share ownership by active investors seems to lead to more favorable stock market reactions around FDI announcements. In Table 4, we show the results from three regressions of 2-day CAR against FX strength and volatility with four control variables: relative size, host country size, FCFRATIO, and block ownership. Since entry mode, currency strength, and volatility may interact to affect shareholders wealth change, we also include SUBS, SUBS*FXSTRONG, and SUBS*FXVOLAT to see the additional impact of subsidiary choice. The first column represents the coefficients and P values from a regression for the whole sample. Results from regressions for the US and non-US samples are presented in the second and third columns, respectively. Choosing a subsidiary instead of a JV seems to lead to a significantly negative CAR (coefficient=1.724). Home currency strength seems to have a significant negative effect on CAR (0.019 coefficient) for the parents of IJVs. For the shareholders of subsidiary parents,

H.Y. Baek, C.C.Y. Kwok / International Review of Economics and Finance 11 (2002) 207227 Table 4 Results of OLS regressions of CARs around FDI announcements Dependent variable: CAR Sample Intercept SUBS FXSTRONG SUBS * FXSTRONG FXVOLAT SUBS * FXVOLAT RELSIZE HOSTSIZE FCFRATIO BLOCKO N P value of Fitness R2 Adj. R2 All 0.007 (.532) 1.724* (.089) 0.019** (.035) 0.037* (.059) 0.005*** (.008) 0.006 (.104) 0.010** (.032) 0.002 (.276) 0.013 (.306) 0.057*** (.000) 80 .004 .280 .188 US 0.011 (.385) 0.027 (.142) 0.021* (.053) 0.031 (.115) 0.006** (.020) 0.004 (.371) 0.009** (.028) 0.001 (.614) 0.018 (.157) 0.055*** (.003) 61 .003 .370 .258 Non-USa

223

0.010 (.756) 0.476** 0.012 (.668) 0.524*** (.004) 0.001 (.891) 0.033*** (.002)

30 .002 .520 .423

These three columns present the results from the regressions of 2-day CARs to the partners shareholders around announcements. Reported in parenthesis are the P values from the tests to see if each coefficient is significantly different from zero. Coefficients of HOSTSIZE are multiplied by 10,000. Substitution of RDRATIO with FCFRATIO, or INSTO with BLOCKO does not qualitatively change the results. All variables are described in the Table 1. a We dropped the four control variables for non-US sample, since the number of observation increases from 20 to 30 without changing the basic results. All the coefficients for the control variables from the regression were insignificant. * Denotes the statistical significance at the 10% level. ** Denotes the statistical significance at the 5% level. *** Denotes the statistical significance at the 1% level.

however, the negative wealth impact is totally offset by a positive impact of home currency strength (0.037 coefficient). The negative impact of home currency strength to JV parents, and the positive and greater additional impact to subsidiary parents seem to consistent for the US sample and the non-US sample. We take these results to be consistent with Hypothesis 2. For the whole sample, the host currency volatility has a positive relationship to CAR for the JV parents, but its additional effect on subsidiary parents shareholder wealth is negative and large enough to lead to negative total effect of volatility on subsidiary parents shareholder wealth. For the US firms, host currency volatility is positively related to shareholder wealth and choice of a subsidiary form does not decrease shareholder wealth. The US sample supports the flexibility option hypothesis (Hypothesis 4A). For the non-US firms, volatility does not decrease the shareholder wealth when a JV is chosen but decreases their wealth when a subsidiary is chosen. The non-US sample supports the international diversification hypothesis (Hypothesis 4). The size of foreign affiliate relative to parents seems positively related to the shareholder wealth changes, and the relationship between host country GDP per capita and

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Table 5 Results of logit regressions of subsidiary versus JV Dependent variable: SUBS Sample Intercept FXSTRONG FXVOLAT RELSIZE HOSTSIZE N P value of Fitness All 1.052 0.175 0.152 0.081 0.300 100 .312 (.198) (.823) (.339) (.810) (.153) US 1.268 (.163) 0.459 (.617) 0.207 (.287) 0.366 (.617) 0.100 (.692) 76 .635 Non-US 1.945 (.968) 2.418** 1.15* (.080) 1.338 (.430) 1.90 (.992) 24 .048

Three columns show the results from the logit regressions of subsidiary versus JV for the whole sample, the US sample, and the non-US sample, respectively. Reported in parenthesis are the P values from the tests to see if each coefficient is significantly different from zero. HOSTSIZE coefficients are multiplied by 10,000. * Denotes the statistical significance at the 10% level. ** Denotes the statistical significance at the 5% level.

CAR is insignificant. Consistent with the univariate tests, agency problem proxies show negative coefficients and active ownership proxies have a strong positive relationship with CAR. In Table 5, we provide the results from the logit regressions of the dichotomous variable SUBS against the FX strength, volatility, relative size, and host market size variables. Since the regression for the whole sample does not show any significant results in the first column of Table 5 and the tests of mean difference in Table 3 show some contrasting results for the US and non-US parents, we divide the sample into US and non-US groups. The coefficient for home currency strength is positive and significant for the non-US parents. For foreign firms that plan to make direct investments in the US, a stronger home currency seems to increase the propensity to choose a subsidiary as an entry mode and Hypothesis 1 is partially supported. The coefficients for the host currency volatility show opposite signs, too. Host currency volatility seems to be significantly negatively related to the propensity to choose a subsidiary for non-US parents. Hypothesis 3 is supported for non-US firms. Although a positive coefficient for US parents seems to support Hypothesis 3A, it is statistically insignificant. We conjecture that non-US firms, when making foreign entry mode decisions, value international diversification effects higher than the flexibility option effects, while the flexibility option seems to be more important to the US firms.

6. Discussion For the sample of FDIs related to the US in 1995, non-US firms are more likely to choose a subsidiary when their home currencies are stronger. The shareholders wealth change around the announcements of a foreign subsidiary is significantly higher under a stronger home

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currency than under a weak one. When the home currency is weaker than the average of the previous 3 years, the average CAR for subsidiary parents is significantly less than that for JV parents for the whole sample and especially for the non-US sample. International diversification hypothesis seems to better explain the non-US firms foreign entry mode decisions and the stock market reactions to those choices. For non-US firms, host currency volatility is significantly negatively related to the propensity to choose a subsidiary. Shareholders of the non-US firms experience negative wealth change when host currency is more volatile. Under more volatile host currencies, shareholders of the non-US firms benefit significantly more when firms choose a JV than when they choose a subsidiary. Under less volatile host currencies, however, the shareholders of non-US subsidiary parents benefit more than those of JV parents. We interpret the results as a support to the international diversification hypothesis (Hypothesis 3). For the US sample, however, empirical support seems to be mixed. In a multiple logit regression of subsidiary/JV, host currency volatility is insignificantly positively related to the choice of a subsidiary. When US firms make a subsidiary choice, CAR is significantly higher when the host currency is more volatile than when it is less volatile. Additionally, CAR for the JV-choosing US firms is significantly positive only under volatile host currencies. When host currencies are less volatile, CAR for the subsidiary choosers is significantly lower than CAR for the JV choosers in the US sample. A multiple regression of US shareholders wealth changes, host volatility seems to be positively related to the CAR of JV parents shareholders but insignificantly related to the CAR of subsidiary parents shareholders. The observations are not consistent with the joint hypothesis that the flexibility option held by an MNC is more valuable when exchange rates are more volatile and when the affiliate is a subsidiary, and that stock markets recognize the value of the flexibility option. Either the value of the flexibility option does not increase when a parent chooses a foreign subsidiary under a volatile host currency, or the stock markets fail to recognize the value, or both. The phenomenon that firms and stock markets behave differently in the US and in non-US countries is consistent with the upstreamdownstream hypothesis expressed in Kwok and Reeb (2000). When the US firms make FDI decisions (i.e., downstream investments), they usually invest into a riskier country. Since the original risk level is relatively low, the increase in overall risk due to a foreign investment may not be significant. Those US firms, with little consideration of risk diversification, can choose a foreign entry mode that maximizes value through an expansion of their investment opportunity set. If free-riding problems are prevalent among JV partners, a JV partner may not be able to make the optimal decisions to switch production around different economies. A foreign subsidiary, in which the parent has full discretion over decisions, increases the value of a flexibility option more than an IJV does. The flexibility option hypothesis has more explanatory power for the firms operating in a relatively low-risk environment. Alternatively, non-US firms, especially firms in the developing countries are operating in a relatively high-risk environment, and one of their motivations for upstream FDIs is risk reduction through international diversification. Of course, the value of a flexibility option should be the same for two different organizations regardless of risk levels. However, some

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non-US firms, especially the ones headquartered in developing countries, cannot afford to acquire the flexibility option at the expense of additional risk to the already-high level. In conclusion, this study investigates the effect of FX level and volatility on the corporatelevel choice of foreign entry mode and on the shareholder wealth. By examining the sample of inbound and outbound US-related FDI announcements in 1995, the authors expand the literature on the FX and FDI to the company level. Nonetheless, the current study may further improve. Since a sovereign government maintains its own policies on corporate governance, FX, and foreign equity ownership, an examination of the different countries with different policies will provide a better understanding of the effect of those variables in foreign affiliate share ownership. Acknowledgments The authors would like to thank McKinley Blackburn, Gregory Niehaus, Kendall Roth, and the seminar participants at the Southwestern Federation of Administrative Disciplines 2000 Annual Meetings for their valuable comments. This paper has also benefited from the comments of Editor Chen and anonymous reviewers. Chuck C.Y. Kwok gratefully acknowledges the support of the Center for International Business Education and Research (CIBER) at the University of South Carolina for this research project. References
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