This paper explores how much a domestic firm should optimally invest for facilitating export to the international market under uncertainty in nominal/spot exchange rate. We consider the presence of exogenous uncontrollable factors, influencing the fixed costs of exports and enhancing the uncertainty surrounding the exporting prospects. We categorise such additional randomness as a “background risk”, affecting the choice variable (i.e. investment) independent of the endogenous exchange rate risk. In this context, we apply a mean-variance decision-theoretic modelling approach to analyse a risk-averse firm’s optimal investment response to the changes in the distributions of the random spot exchange rate and of the background uncertainty, in terms of the relative trade-off between risk and return. Next, using an unbalanced panel data of 840 exporting Indian manufacturing firms over 17 years, we perform a structural estimation of the theoretical model, derived using a flexible utility function that incorporates all possible risk preferences, in order to demonstrate the key results in our model empirically. For this purpose, using fixed effects model and Heckman’s two-step estimation procedure, we empirically estimate firm-level mark-up(s), as proxy for firms’ risk-premium. This helps us to come up with the estimation of risk aversion elasticities in our context.
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Subhadip Mukherjee, Soumyatanu Mukherjee, Tapas Mishra and Udo Broll
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