Export under Background Risk: A Mean-Variance Decision Analysis for Indian Manufacturing Firms
Research Paper Series (GEP) University of Nottingham, UK, Globalisation, Productivity and Technology Programme, 2020
28 Pages Posted: 16 Jun 2020
Date Written: May 21, 2020
How would accessing foreign markets affect risk exposure of manufacturing firms? Producing for and selling specific goods to foreign markets (exports) require specialized attention. For example, manufacturing firms are exposed to idiosyncratic shocks in their global supply chains, such as exchange rate volatility, asset market frictions, transaction risks, credit tightening, and so on. Given this background, we probed production and exporting decision for a manufacturing firm (that serves both domestic and foreign markets) in the context of firm-specific and industry-specific shocks on trade, with a view of searching for optimality. These shocks are aggregated to form a type of risk that literature labels as ‘non-hedgeable’ background risk. We also propose that background risk is dependent on direct (endogenous) risk pertaining to fluctuations in the spot/nominal exchange rates. To test for potential optimal conditions, we employ a mean-variance decision-theoretic modelling approach. This approach was selected in order to trace out the comparative static responses of optimal export sales following the changes in the distribution of background risk or due to the dependence structure between the two sources of risks (i.e., background risk and exchange rate risk). Our contribution includes isolating all comparative static effects of these changes in the context of optimal production and exporting decisions. In particular, we consider the relative trade-offs between risks and returns, and offer intuitive economic theory based interpretations of our results. In order to demonstrate robustness of the key results in our model empirically, we utilised an unbalanced panel data of 1,273 exporting Indian manufacturing firms over the time period of 1996-2017 to perform a structural estimation of our theoretical model. This model is derived using a flexible utility function that incorporates all possible options of risk preferences. Through this approach, we are able to estimate risk aversion elasticities specific to our context.
Keywords: Exports, Background risk, Background risk –augmented profit, Decision under risk, Mean-variance model, Risk aversion
JEL Classification: D21, D81, F41
Suggested Citation: Suggested Citation