Risk Reduction by International Diversification
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* The objective of this paper is to report empirical tests of the opportunities available to a multinational firm for reducing the risk of its profits. Interest in this risk dimension, as well as in the traditional level of profits, has developed due to the application of portfolio theory in an international context.1 The first such application of the theory of portfolio selection under conditions of uncertainty, as developed by Tobin (1958) and Markowitz(1959), was by Herbert Grubel (1968). He demonstrated that it was possible for individual asset holders to reduce risk by holding an efficiently diversified portfolio of international assets. His analysis considered financial capital flows, as did work by Levy and Sarnat (1970), Millerand Whitman (1970), and Grubel and Fadner (1971). Itcan be extended in a new direction by consideration of direct investment, as attempted by Cohen (1972) and Severn (1974). The characteristic of direct investment is that the investor retains control over the investment. For example, the parent firm of a multinational corporation may both invest in a foreign subsidiary and control the operations of that subsidiary. Recent work in the field of international investment has shown that direct investment is motivated by the existence of market imperfections: Kindleberger (1969), Johnson (1970), Caves (1971), Knickerbocker (1973). [For an interpretation of these studies see Parry (1973) and Rugman (1975).] These studies show that the motivation of direct investment occurs at the firm level owing to an imperfect international market. The foreign operations of multinationalfirms allow the firmto maximize its overall level of profits. Itis demonstrated in this paper that the multinationalfirmalso enjoys the additional advantage of less risk in its profits than does a similarly sized firm selling most of its goods in one national market alone. More specifically, stability of earnings through time is an increasing function of the ratio of foreign to total operations. The advantage of risk reduction exists due to the possibility of diversification of sales in various national economies, provided that the fluctuations of these economies are not perfectly positively correlated. Inthis paper the theory of portfolio analysis is used to justify variance as a suitable proxy measure of risk. No distinction is attempted between systematic and unsystematic risk since it is empirically difficult and even theoretically inappropriate to use the Capital Asset Pricing Model (CAPM) in an analysis of direct investment. The CAPM, developed by Sharpe (1964) and Lintner(1965), would be suitable if financial capital flows were being examined as in the work by Solnik (1974 a,b) and Lessard (1974). To use the CAPM it is necessary to have a perfect international capital market and an international risk free asset. These are inappropriate assumptions to make when testing direct investment, and the use of a CAPMwould be inconsistent with the argument that direct investment is motivated at the firm level by market imperfe
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