Foreign direct investment and exchange rate uncertainty in imperfectly competitive industries

This paper investigates the relationship between exchange rate uncertainty and the location of US foreign direct investment in Europe. We adopt a mean-variance approach to the standard q theory of investment in order to highlight the impact of exchange rate volatility and exchange rate correlation on investment. A firm concerned with both maximizing profits and minimizing risk would exploit any correlation between exchange rate movements to reduce the variance of its total profit. We estimate US foreign investment in the UK and in Continental Europe in a panel of seven manufacturing industries. Our results show that US firms investing in Europe tend to be risk-averse and decrease their investments as exchange rate volatility rises. Market power does not seem to reduce the effects of exchange rate volatility on FDI. We found strong evidence that the UK is the preferred European location for US investors, since an increase in the correlation between the sterling dollar exchange rate and the euro dollar exchange rate tends to relocate US investment from the Euro Zone to the UK.