Decision support for foreign investment strategy under hybrid uncertainty


Decision support for foreign investment strategy under hybrid uncertainty

Po-yuan Chen a,⇑, Horng-jinh Chang b
a Department of Financial and Tax Planning, Jinwen University of Science and Technology, No. 99, An-chung Rd., Sindian District, New Taipei City 23154, Taiwan, ROC
b Graduate Institute of Management Sciences, Tamkang University, No. 151, Ying-chuan Rd., Tamsui District, New Taipei City 25137, Taiwan, ROC

a r t i c l e i n f o

Keywords:
Decision support
Foreign investment
Hybrid uncertainty

a b s t r a c t

Empirical evidences show that Japan-based companies moved their major operations to the USA due to
the currency appreciation of Japanese Yen in 1980s. However, the multinational firms moving their oper-
ations abroad still face both the risk of foreign price and the risk of foreign exchange rate. According to
the purchasing power parity (PPP) and interest rate parity (IRP), the foreign exchange rate has associa-
tions with the relative price and the relative interest rate between two countries. Therefore, when the
price and the interest rate evolve stochastically as proposed by many scholars, we can anticipate the ran-
domness of the foreign exchange rate. By integrating these three sources of risks as a hybrid uncertainty,
we propose a framework for corporate valuation and investment strategy. We analytically derive corpo-
rate value for those multinationals in question and then numerically obtain the real option value by
Monte Carlo simulations, based on which we investigate the optimal entry strategy. The sensitivity for
corporate value, optimal entry time, and real option value are analyzed. The results suggest a decision
support process for foreign investment timing strategy under the hybrid uncertainty. The managerial
implication of this work is that the optimal investment strategy for the multinational firms with foreign
operations depends on some market and risk factors, as well as correlations among them.

� 2011 Elsevier Ltd. All rights reserved.

1. Introduction

Global business community today faces risk exposures not only
from volatile product prices but also from foreign exchange rates.
Recently, many countries compete with their counterparts for
currency depreciation, attempting to gain export advantage. As a
consequence, the game of currency arises, making the foreign ex-
change market more volatile and weakening the profits of multina-
tional firms with foreign operations. For example, Japanese Yen
reached its 15 yrs high up to $84 JPY/USD in 2010, causing many
Japan-based firms abroad to suffer from losses denominated in
domestic currency. Kim and Hur (2009) addressed the importance
of foreign exchange management and proposed a model to inves-
tigate the effects of foreign exchange on firm performance using
genetic algorithm and VaR. Kogut and Chang (1996) found that
in order to maintain the exports value of domestic operations un-
der the appreciation of Japanese yen against the US dollar, Japanese
companies switched their supporting export-oriented trades to
establishing the foreign operations directly in the United States
during the period of 1970s through 1980s. Studies of Rangan
(1995) found that American firms tend to keep their ex factory

dollar prices constant, allowing foreign currency prices to fluctuate
with exchange rates. By contrast, Japanese and German firms were
found to set foreign prices in a manner sensitive to market condi-
tions. Some researchers also advocated that the volatility of foreign
exchange rate is related to the trends towards foreign direct invest-
ments. According to the purchasing power parity (PPP), the rela-
tionship between the foreign exchange rate and the price has
been tested by many researchers, for example by Perron and
Vogelsang (1992). Dornbusch (1988) asserts that the movements
in the nominal foreign exchange rate between two countries and
the movements in their respective price indexes adjust through
time to maintain the constant purchasing power. Moreover, the
interest rate parity (IRP) suggests that exchange rate is also corre-
lated with interest rates in two countries. We therefore consider
the foreign exchange rate, the interest rate and the foreign price
as mutually correlated stochastic processes. We aim to formulate
a stochastic model to value the multinationals which move the
operations to foreign countries.

Regarding the corporate valuation approaches, Seng and Lai
(2010) classifies business valuation methods into three categories:
market-based, income-based (discounted cash flow, DCF) and as-
set-based approaches. The asset-based model dates back to the
work of Merton (1974), who proposed the stochastic asset value
in a call option, whose exercise price is the contingent claim on
debt. Based on his option framework, many related models have
been developed by Black and Cox (1976), Landes and Loistl

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doi:10.1016/j.eswa.2011.10.007

⇑ Corresponding author. Fax: +886 2 8212 2399.
E-mail address: mikecpy@ms7.hinet.net (P.-y. Chen).

Expert Systems with Applications 39 (2012) 4582–4589

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http://dx.doi.org/10.1016/j.eswa.2011.10.007
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http://dx.doi.org/10.1016/j.eswa.2011.10.007
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(1992), etc. More recent study on option-type investment strategy
can be found in the work of Yuan (2009), who proposed a frame-
work to investigate expansion strategy under price uncertainty
from the aspect of an industry. Both the real option value and
the investment timing strategy are obtained through simulation–
optimization mechanism in this model. On the other hand, the
works employing the DCF to valuate business can be found in the
works of Rappaport (1986), and Copeland, Koller, and Murrin
(1996). The main theme of these works lies in the discounted pres-
ent value of all future cash inflows. Casey (2001) computed the
discounted value from a series of uncertain future payments until
the date of insolvency and then obtained the present value
distribution.

Inspired by previous research results, we propose a valuation
framework by integrating the foreign exchange rate, the foreign
price, and the interest rate as a hybrid uncertainty for those com-
panies with foreign operations. Subsequently, we investigate the
entry strategy for the foreign operations and obtain the corre-
sponding real option value.

In the work of Kim, Won, and Bae (2010), corporate value is de-
rived from the present value of future dividend flows. Instead, the

corporate value is derived in our work by discounting all future
profits. These profit flows evolve as a stochastic process due to
the assumption of randomness in interest rate, foreign exchange
rate and foreign price, as illustrated in Figs. 1 and 2 based on the
historical price quotes for the LCD product denominated in New
Taiwan dollar (NTD) and on the quotes for the NTD exchange rate
against the US dollar (USD) during the period of January 2000
through June 2009 acquired from the Taiwan Economic Journal
(TEJ) database. The sensitivity of corporate value is analyzed to
provide readers with more insights into the interactions among
the following factors: the drift and the volatility of the stochastic
foreign exchange rate and the foreign price, the price elasticity of
demand, and the correlation between the exchange rate and the
foreign price.

This paper is organized as follows: Section 1 introduces the cor-
responding valuation models, introduced by previous scholars.
Section 2 presents the formulation of corporate value in the con-
text of stochastic price, interest, and exchange rates under an in-
verse demand function. The analytical solution for the proposed
corporate value is then obtained. Based on derived corporate value,
Monte Carlo simulations for real option value and optimal entry

Fig. 1. The monthly price process denominated in US dollar for the LCD product.

Fig. 2. The monthly foreign exchange rate process quoted as NT dollars against per US dollar.

P.-y. Chen, H.-j. Chang / Expert Systems with Applications 39 (2012) 4582–4589 4583



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