Minimizing the geographical risk of foreign direct investment

Increasingly, it has been recognized that the location decision of multinational firms (MNFs) is the direct result of investment decisions. While MNFs can geographically distribute their products through export diversification and productlicensing agreements, evidence indicates that foreign direct investment (FDI) insures greater profit stability. Although a number of theories have been advanced to explain the global pattern of FDI by a MNF, none have considered the interdependence of production environments in the MNF's investment decision. This paper presents a mean-variance portfolio model as a method of risk aversion that an MNF can use when planning a locational strategy. In this approach, risk is measured by the covariance of production return over a given time. It is hypothesized here that production correlation and hence risk is a distance-decay function. Thus, a covariance risk aversion strategy would result in a global distribution of investment for a given commodity rather than being concentrated in a single country. An empirical example of automobile production supports this risk-distance hypothesis and demonstrates that international cross-investment is a logically consistent mode of firm behavior.