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Measuring the Foreign Exchange Exposure of Offshore Assembly Operations

Steve A. Johnson

Abstract


Faced with the ever present need to control costs and expand markets, many domestic manufacturers have shifted to offshore assembly and production to augment their domestic operations. Multinational corporations establish basic assembly operations in strategically located, less-developed countries and capitalize on the lower relative costs of labor associated with the local workforce. These offshore operations, designed to provide only the labor intensive stages of the firm's production cycle, place little emphasis on the local distribution of the final product. The emergence of concentrated pockets of these operations has also fueled industrial growth in many nontraditional areas. Along with raising some highly charged social issues, the prosperity of this specific segment of direct foreign investment revives the ever-present questions concerning the risks of nondomestic investment. Specifically, to what extent are investments in nondomestic assembly operations at risk to changes in foreign exchange rates?

Recent empirical studies (Davila 1990, Jorian 1990) have shown the observable impact that exchange rate changes have had on the share returns and equity values of multinational enterprises. However, little work, empirical or theoretical, exists on estimating the relative magnitude of these responses. The reason that foreign exchange risk measures have not been developed in prior academic research is either (1) the lack of a specific valuation model for multinational operations, or (2) the nondomestic valuation models that do exist usually prove to be too complex to accurately assess the exposure of particular nondomestic enterprises. This article attempts to quantify the specific foreign investment risk of offshore operations into manageable as well as intuitive measures.


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Print ISSN: 0886-5655
Online ISSN: 2159-1229

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