Exchange rate uncertainty

Numerous researchers have noted that rapid and unanticipated changes in the value of host countries’ currencies have the potential to affect a firm’s operation and performance in foreign markets (Belderbos & Zou, Reference Belderbos and Zou2009, Lee & Makhija, Reference Lee and Makhija2009a, Reference Lee and Makhija2009b). For example, Campa (Reference Campa1993) studied the impact of exchange rate volatility on foreign entry, and Lee and Makhija (Reference Lee and Makhija2009a, 2009Reference Lee and Makhijab), and Cuypers and Martin (Reference Cuypers and Martin2010) studied the impact of unexpected exchange rate fluctuations in domestic markets on real options value or real option based behavior of MNEs. Huchzermeier and Cohen (Reference Huchzermeier and Cohen1996), Pantzalis, Simkins and Laux (Reference Pantzalis, Simkins and Laux2001), and Miller and Reuer (Reference Miller and Reuer1998a, Reference Miller and Reuer1998b) examined the real option value effects of such asymmetrical responses to differing unanticipated movements in exchange rates (i.e., appreciation [vs.] depreciation). Similarly, Lee and Song (Reference Lee and Song2012) assessed whether MNEs reallocate production levels of subsidiaries differently depending on whether they are located in countries characterized by currency depreciation or appreciation. The findings of these studies support the importance of real options investments under exchange rate uncertainty.

Since uncertainty reflects unanticipated change, its measurement poses significant problems since it is not easily captured. Thus, a critical issue with regard to exchange rate uncertainty is the way in which it is measured. In this respect, we find that two approaches have been predominantly used by researchers examining exchange rate uncertainty. One is the approach adopted by Campa (Reference Campa1993) and Goldberg and Kolstad (Reference Goldberg and Kolstad1995), in which the standard deviation of monthly exchange rates is used to capture the impact of exchange rate volatility on FDI entry. Belderbos and Zou (Reference Belderbos and Zou2009) also use annual volatility of exchange rates of nine Asian countries before and after Asian economic crisis during 1995–1999 to examine the impact of exchange rate uncertainty on foreign subsidiary exits. To explain FDI timing, type and mode of entry, Hauser’s (Reference Hauser2005) measure in this regard takes into account the yearly standard deviation of monthly residuals in a country, divided by the mean exchange rate level for the year. This method is also employed by Darby, Hallett, Ireland, and Piscitelli (Reference Darby, Hallett, Ireland and Piscitelli1999). Song, Makhija, and Lee (Reference Song, Makhija and Lee2014) also employed this method for computing exchange rate volatility in their study on differences between within- and across-country flexibility.

A second approach, seen in more recent studies, involves a more sophisticated econometric method to capture volatility. An example is Lee and Makhija (Reference Lee and Makhija2009a, Reference Lee and Makhija2009b) who study of the impact of exchange rate volatility of Korean currency on the real options value of international investments of Korean MNEs using a generalized autoregressive conditional heteroskedasticity (GARCH) model to compute annual volatility in exchange rates using monthly foreign exchange of Korean currency and stock price of Korean MNEs. A GARCH model offers significant advantages over the standard deviation approach discussed above. One advantage is that it better captures the unanticipated change in exchange rates that gives rise to uncertainty. Another advantage in employing a GARCH model in real options research is that it enables to control for any trends that might exist for each period in the time series data (Folta & O’Brien, Reference Folta and O’Brien2004). Cuypers and Martin’s (Reference Cuypers and Martin2010) measurement of exchange rate volatility as the ratio of the difference between average annual official rate and average annual parallel rate out of average annual official rate can be applied to the contexts where a central government plans and intervene official exchange rates in its domestic market.

Country-level uncertainty

Some real options researchers have identified and utilized conditions of significant and abrupt change in the macroeconomic environment of a given country context as an important source of uncertainty and relevant for testing real options arguments. For instance, Chung and Beamish (Reference Chung and Beamish2005), Grewal and Tansuhaj (Reference Grewal and Tansuhaj2001), and Chung et al. (Reference Chung, Lee, Beamish and Isobe2010) use the backdrop of the Asian economic crisis during 1997–1999, during which local stock prices fell precipitously and unexpectedly in each country affected by an average of 50%. Interestingly, Chung and Beamish (Reference Chung and Beamish2005) find that during this period, wholly owned greenfield subsidiaries are more likely to survive than greenfield JVs and acquired wholly owned subsidiaries. Lee and Makhija (Reference Lee and Makhija2009a) also use the context of the Korean economic crisis that occurred in late 1997 to assess whether firms used their international investments flexibly to accommodate the uncertainty. These studies employed a natural experiment approach to study the effects of unanticipated change in a country’s macroeconomic context on real options investments.

A number of other studies compare countries in terms of the relative uncertainty of their particular macroeconomic environments. In this regard, Hauser (Reference Hauser2005) utilize the EUROMONEY country risk index to study effects of differing levels of host country risk on ownership level in IJVs. By the same token, Erramilli and D’Souza (Reference Erramilli and D'Souza1995) create a dummy variable that distinguishes between entries into low-risk and high-risk countries for their study on FDI entry strategies. Cuypers and Martin (Reference Cuypers and Martin2010) consider the effects of institutional riskiness for IJVs, based on whether or not they operate in special economic zones or open coastal cities. Reuer and Tong (Reference Reuer and Tong2005) examine risk relating to property rights and political upheaval for the explicit option to acquire in an IJV. These studies all use existing measures of institutional or country risk to assess uncertainty.

Demand uncertainty

Changes in a host country’s industry structure or fluctuations in local market demand can be highly unanticipated, and may require the firm to rapidly adapt its operations to these newly emerging conditions. For this reason, researchers have also focused on industry- or demand-level uncertainties within a host country. For example, Folta and Miller (Reference Folta and Miller2002) argue that the level of demand uncertainty and size of the market have a combined effect on option value. To assess product market uncertainty, Kogut (Reference Kogut1991) measured the difference between actual and forecasted shipment growth rates in order to examine the value of real options associated with international joint ventures. He found that such uncertainty influenced the value of these options, which were a platform investment to monitor the market. Campa (Reference Campa1993) and Goldberg and Kolstad (Reference Goldberg and Kolstad1995) use a similar approach to examine the influence of uncertain market demand on FDI entry timing. On the other hand, some other scholars have measured demand uncertainty with Likert-type questions that reflect the potential size and growth rate of the target market. Although an unusual approach in the literature, an example of this is Brouthers and Dikova’s (Reference Brouthers and Dikova2010) study of a sample of Western European firms entering the emerging economies of Eastern Europe.

The types of uncertainty in the international environment considered by researchers are illustrated in Table 1.

Table 1 Uncertainty types and measures in the international real options literature

Note: FDI=foreign direct investments; IJV=international joint ventures; JV=joint ventures.

Growth options

Due to their ability to minimize firm outlays, minority investments, strategic alliances, or joint ventures are thought to help firms retain flexibility under high exogenous uncertainty as compared with majority investments or acquisitions (Kogut, Reference Kogut1991; Folta, Reference Folta1998; Chi, Reference Chi2000; Tong, Reuer, & Peng, Reference Tong, Reuer and Peng2008; Cuypers & Martin, Reference Cuypers and Martin2010; Li & Li, Reference Li and Li2010; Reuer & Tong, Reference Reuer and Tong2010). For example, Kogut (Reference Kogut1991) found that firms tend to choose international joint ventures as growth options under high demand uncertainty level and adjust the choice according to the changing market condition. Similarly, Chi (Reference Chi2000) and Chi and McGuire (Reference Chi and McGuire1996) argue that strategic alliances as growth options investments are low-cost vehicles for learning about and from partners. Tong, Reuer, and Peng (Reference Tong, Reuer and Peng2008) find that minority international joint ventures carry more growth options value, from their empirical analysis of Stern Stewart’s annual rankings of the 1,000 largest US publicly traded companies based on their Market Value Added. Relevantly, Reuer and Tong (Reference Reuer and Tong2010) find that established firms are more likely to form partnerships with firms after an initial public offering due to more visibility of firms having an initial public offering, which can help investors recognize the embedded growth opportunities and garner their alliance activities. Cuypers and Martin (Reference Cuypers and Martin2010) also find that exogenous uncertainty related to exchange rates, demand, or institution in Chinese context leads foreign multinational corporations to choose minority joint ventures with Chinese firms. Similarly, Li and Li (Reference Li and Li2010) also find that MNEs tend to choose more flexible rather than more committed ownership strategies that allow for future adjustment of investment decisions under high uncertainty in China.

Switching options

While growth options focus on the growth potential in a host country market, the option to switch reflects a need for change in the firm’s current strategies from one country to another. When an MNE faces an unpredictable foreign environment, it has difficulty in adapting its strategy to new circumstances, which can in turn negatively affect its overall international operations and performance (Rivoli & Salorio, Reference Rivoli and Salorio1996). Under these circumstances, it needs to be able to reallocate resources flexibly to other host countries in response to abrupt changes in any given host country. The external uncertainty faced by the firm may be due to fundamental shifts in the level of demand or the relative costs of inputs. These abrupt changes in factor and product markets require it to hastily adjust or even radically reconfigure its value chains in response to new opportunities for, or threats to, profitable production (Kogut, Reference Kogut1991).

A bundle of investments can in fact enhance options to switch operations across countries, allowing the firm to change its strategies in line with environmental fluctuations. In particular, research shows that firms gain operational flexibility through cross-country shifts in its value chain activities when operating or market conditions in one country becomes much less advantageous (Allen & Pantzalis, Reference Allen and Pantzalis1996; Tang & Tikoo, Reference Tang and Tikoo1999). In that regard, Allen and Pantzalis (Reference Allen and Pantzalis1996), Lee and Makhija (Reference Lee and Makhija2009b), and Tang and Tikoo (Reference Tang and Tikoo1999) find the real options value of multinationality or high breadth of FDI. Also consistent with this argument, it has been reported that a broader network of countries enables firms to arbitrage markets by shifting production factors across national borders and by transferring resources within their network of affiliates located in one or more foreign countries (Kogut & Kulatilaka, Reference Kogut and Kulatilaka1994b; Tang & Tikoo, Reference Tang and Tikoo1999; Lee & Makhija, Reference Lee and Makhija2009a; Chung et al., Reference Chung, Lee, Beamish and Isobe2010). FDI characterized by options to switch across countries allow the firm to mitigate effects of major currency swings and corresponding economic exposure that bring about changes in relative factor costs across national environments (Allen & Pantzalis, Reference Allen and Pantzalis1996; Kogut & Chang, Reference Kogut and Chang1996; Miller & Reuer, Reference Miller and Reuer1998a, Reference Miller and Reuer1998b). Relevantly, Huchzermeier and Cohen (Reference Huchzermeier and Cohen1996) find the enhanced value of switching value chain activities following cross-country currency swings. Recently, Chung et al. (Reference Chung, Lee, Beamish and Isobe2010) examined MNEs’ exit decision from the across-country switching options perspective and commonly argued that MNEs having more switching options in their FDIs have less exit rates among their foreign subsidiaries. Similarly, Lee and Song (Reference Lee and Song2012) found that MNEs are able to relocate their production volume from more costly locations to less costly ones. On the other hand, Reuer and Leiblein (Reference Reuer and Leiblein2000) and Tong and Reuer (Reference Tong and Reuer2007) raised the possibility that MNEs may not enjoy the value of multinationality due to complex management and costly coordination of dispersed operations across countries. On the other hand, Dikova, Smeets, Garretsen, and van Ees (Reference Dikova, Smeets, Garretsen and van Ees2013), found that switching options are more helpful than growth options when firms are faced with unexpected financial crises in the countries in which they operate.

Note that these two types of options contrast greatly – while growth options imply limited levels of investment initially, switching options require significant levels of investments diversified across countries. They also imply greatly contrasting levels of ownership and control within the firm’s FDI portfolio. Relevantly, Song, Makhija, and Lee (Reference Song, Makhija and Lee2014) examined contrasting impact of two types ownership on the real options value of multinationality from two options perspective.

Table 2 summarizes these key options types embedded in international investments as discussed in the IB literature.

Table 2 Options types in the international real options literature

Note: FDI=foreign direct investments; IJV=international joint ventures; JV=joint ventures; MNE=multinational enterprise.

Upside potential

Chi and McGuire (Reference Chi and McGuire1996) argue that the presence of an explicit option clause in joint ventures will depend on three conditions: (1) the level of uncertainty, (2) the anticipation of a change in the relative bargaining power between the two parties during their collaboration, and (3) ex ante asymmetry among both parties in their expected pay-offs of the option. Based on this logic, Chi and McGuire (Reference Chi and McGuire1996) and Chi (Reference Chi2000) developed empirical real options models to rigorously investigate the conditions under which options provided by JVs are valuable. Both studies concluded that the real options value of a JV is higher when partners have divergent expectations of the value of the joint assets. On the one hand, the partner with higher valuation is willing to pay a higher price than the other partner, which results in a mutually beneficial trade in their stakes. On the other hand, if partners have similar valuation with respect to the joint venture, the option to acquire cannot be realized and partners cannot benefit from any trade in their stakes, thereby leading to lower value of the option to acquire.

Researchers have developed multiple measures to assess real option value. For example, Tobin’s q is used as a standardized measure of the value ascribed to a firm by investors. In a typical Tobin’s q formula, the denominator (i.e., book value of total assets) represents the investment input in the firm, and the numerator (i.e., market value of common stock+book value of preferred stock+book value of debt) captures the value created by the firm with these inputs (Lee, Makhija, & Paik Reference Lee, Makhija and Paik2008; Lee & Makhija, Reference Lee and Makhija2009a, Reference Lee and Makhija2009b). While alternative measures such as return on equity or return on asset are expected to differ across firms depending on the risk of the firm, Tobin’s q is a ‘forward looking’ measure that adjusts for such risk. Since the market value of the firm depends on the growth potential of the firm, as well as the efficiency of management to actualize it, Tobin’s q as a performance measure has been suggested to be more appropriate than other short-run measures such as return on equity or return on asset (Lee, Makhija, & Paik, Reference Lee, Makhija and Paik2008). Similarly, stock ratio is also used to assess forward-looking value of the firm, measured by market value over book value of common stock (Folta & O’Brien, Reference Folta and O’Brien2004). Nonetheless, these measures have also been criticized for the fact that they reflect values generated by multiple firm activities and not just those relating to real options. These confounding effects are thought to reduce the appropriateness of Tobin’s q and similar measures for assessing real options value (Tong & Reuer, Reference Tong and Reuer2007). In an effort to address this criticism, Bulan (Reference Bulan2005) eliminated Tobin’s q models using observations with more than 20% changes in book value to control for possible M&A activities.

Some other ways to measure additional value associated with real options have also been introduced in the international literature. For example, in order to measure the value of flexibility derived from firms’ international investments, Allen and Pantzalis (Reference Allen and Pantzalis1996), Thomas and Eden (Reference Thomas and Eden2004), and Song, Makhija, and Lee (Reference Song, Makhija and Lee2014) use the firm’s excess market value, or the ratio of market value plus the book value of debt minus total assets, all divided by total net sales. They extract the excess market value of each MNE from the averaged excess market value of all the domestic firms in the same industry, which reflects the value of multinational flexibility of the MNE. Tong and Reuer (Reference Tong and Reuer2007), and Tong, Reuer, and Peng (Reference Tong, Reuer and Peng2008) decompose the value of the firm into the value of assets in place and the value of future growth opportunities (V _GO), which is measured by the firm’s total market value (V) less the capitalized value of its current earnings stream (i.e., current earnings/discount rate). Thus, a firm’s growth option value is computed as V _GO/V.

While the measures above impute flexibility through assessment of additional value created by an option under uncertainty, Lee and Makhija (Reference Lee and Makhija2009a) developed new measures in order to assess actual operational flexibility created by options within international investments. One such measure of operational flexibility is the use of a firm’s preexisting export platform investments for sales to new customers when faced with environmental uncertainty. To assess this, they subtracted the firm’s export sales to its foreign subsidiaries and to existing long-term customers from its total export sales, and then divided the resulting value by the firm’s total export sales. A second measure captured the extent to which the firm actually shifted its production or sales from one foreign investment location to another in response to increases in uncertainty.

Downside risk

A firm’s investments may also provide options that limit the likelihood of below-target performance outcomes, referred to as downside risk (Miller & Reuer, Reference Miller and Reuer1996; Reuer & Leiblein, Reference Reuer and Leiblein2000). Thus, several measures of downside risk have been utilized in order to assess whether options embedded in international investments to reduce the firm’s downside losses. Miller and Reuer (Reference Miller and Reuer1996) argue that downside risk measures should explicitly incorporate the notion of reference (i.e., target or aspiration) levels and therefore address decision makers’ tendency to consider risk in terms of negative outcomes or hazard rather than as variance in outcomes, as is typical in empirical research in the field. Thus, in contrast to traditional variance-based measures of risk that incorporate the entire distribution of firm performance, more recent measures of downside risk intend to solely capture organizational outcomes below some target values (Reuer & Leiblein, Reference Reuer and Leiblein2000; Tong & Reuer, Reference Tong and Reuer2007).

Reuer and Leiblein (Reference Reuer and Leiblein2000) used three measures of downside risk operationalized by return on asset, return on equity, and financial beta to examine whether firms are able to take advantage of international wholly owned investments and IJVs to reduce their downside losses. Surprisingly, they found that neither type of investment reduced downside risk. They attributed lack of significant effects to multinational complexity and costly coordination over foreign subsidiaries. Using the same measures, Tong and Reuer (Reference Tong and Reuer2007) investigated the relationship between multinationality and downside risk, moderated by ownership level at the FDI portfolio level and cultural distance between host and home countries. They found that multinationality has a U-shaped relationship to downside risk. Based on these findings, the authors argued that downside risk initially falls as firms enter more foreign countries, and later rises due to high coordination costs of highly dispersed operation across country borders. In a similar vein, Driouchi and Bennett (Reference Driouchi and Bennett2010) explored the relationships between real options awareness, managerial learning and the risk implications of switching options in multinational operations. They found that MNEs with high managerial awareness about their real options are better able to reduce their downside risk through the breadth of their international investments.

Table 3 presents the various measurements for real options value found in the current literature.

Table 3 Valuation of real options in the international real options literature

Note: ROA=return on asset; ROE=return on equity; EVA=economic value added.

Exercise timing

The issue of timing in the exercise of a real option plays an essential role in determining how these actually provide firms with value. In general, the literature suggests that an option is valuable when it allows the firm to wait until uncertainty is resolved before committing fully in terms of its investment, particularly in industries, which are characterized by irreversible investments and high sunk costs (e.g., Campa, Reference Campa1993; Folta & O’Brien, Reference Folta and O’Brien2004). Consistent with this logic, in examining factors that influence the timing of international investments, scholars such as Dixit (Reference Dixit1989), Campa (Reference Campa1993), Goldberg and Kolstad (Reference Goldberg and Kolstad1995) found that when macro-economic conditions are highly volatile, MNEs tend to delay investment. This is consistent with real options logic in that the value of the option to wait increases under high uncertainty. Others have found that it is when exogenous uncertainty associated with initial investment is resolved or reduced, or when preemptive advantage associated with competition gets larger, that firms are motivated to invest overseas and increase entry into foreign markets (Rivoli & Salorio Reference Rivoli and Salorio1996; Kulatilaka & Perotti, Reference Kulatilaka and Perotti1998; Miller & Folta Reference Miller and Folta2002; Folta & O’Brien, Reference Folta and O’Brien2004). Along with timing, the mode of entry also influences the value derived by the firm from its real option investment. Brouthers, Brouthers, and Werner (Reference Brouthers, Brouthers and Werner2008), Tong, Reuer and Peng (Reference Tong, Reuer and Peng2008), and Cuypers and Martin (Reference Cuypers and Martin2010) examine the influence of high exogenous uncertainty on the types of entry modes that are preferred. They find that minority, alliance, or small-sized investments provide firms with better ability to wait until the uncertainty is resolved.

Exercise conditions

Real options theorists have drawn upon financial options arguments to identify the appropriate conditions of exogenous uncertainty influencing the timing of exercising options and assessing the value-enhancing effects of options such as buyout or divestment of initial investments. Indeed, the literature suggests that more positive external signals play a stronger role in motivating firms to exercise options in the international arena. As an example of how changes in uncertainty impacts the exercise of real options, Kogut (Reference Kogut1991) found that the timing of IJV buyouts is more influenced by favorable market signals reflecting unexpected growth than unfavorable market signals. Chung et al. (Reference Chung, Lee, Beamish and Isobe2010) and Lee and Song (Reference Lee and Song2012) examined the relationship between favorable changes in host countries’ exchange rates and subsequent increase in FDI by MNEs. Using panel data of Japanese FDI in Asian countries during the Asian economic crisis in the late 1990s, Chung et al. (Reference Chung, Lee, Beamish and Isobe2010) test to see if Japanese MNEs actually increased export sales or employment in their foreign subsidiaries to take advantage of depreciating currencies in Asian countries stricken by the crisis. Similarly, Lee and Song (Reference Lee and Song2012) considered whether MNEs actually shift their production according to exchange rate fluctuations in host countries and if their across-country shifts of production lead to better performance. With a Korean FDI data set, they found that foreign subsidiaries respond to favorable and unfavorable change in exchange rates in asymmetric ways, relocating their production from costly subsidiaries to less costly ones via the international network of their parent firm. Similarly, Dikova et al. (Reference Dikova, Smeets, Garretsen and van Ees2013) found that firms faced with an unexpected economic crisis in a host country benefited from the ability to quickly shift their operations to other host countries.

Researchers in IB have also studied the influence of changing uncertainty on the exercise of real options. For example, Fisch (Reference Fisch2009b) tested the effect of receding uncertainty on increases in employment, and found that up to a certain level of uncertainty firms tend to defer their investments, but after they perceive the reduction of such uncertainty they exercise their options. Belderbos and Zou (Reference Belderbos and Zou2009) examined the conditions and timing of foreign subsidiaries’ option to divest in response to adverse macroeconomic change. Using a sample of Asian manufacturing affiliates of Japanese electronics MNEs, they found that low correlations in exchange rates among foreign subsidiaries or solely existing subsidiaries lead to delayed exits even under the influence of hostile macroeconomic conditions such as high labor cost in host countries. On the other hand, Fisch and Zschoche (Reference Fisch and Zschoche2011) found from Germany MNEs that their foreign subsidiaries relocate their employment in flexible responses to differing labor cost growth rates across countries. These studies suggest that both exogenous uncertainty and time-dependent learning can affect exercise (investment) decisions in accordance with firms’ perceptions of uncertainty over time.

Table 4 summarizes the extant literature on the exercise of real options investment.

Table 4 Exercise of real options the international real options literature

Note: FDI=foreign direct investments; IJV=international joint ventures; JV=joint ventures.

Measuring uncertainty

Since exogenous uncertainty is the critical feature of any real options argument, the measures used for uncertainty should reflect the actual contexts in which investment decisions are made by managers. For example, switching options, which facilitate the firm’s movements across countries, are likely to be more valuable in the face of exchange rate volatility than other types of uncertainties, while growth options are more relevant for country-specific uncertainties relating to demand or competition. In this regard, the fact that Reuer and Leiblein (Reference Reuer and Leiblein2000) look at growth options relating to JVs in the context of exchange rate volatility may explain their non-significant findings regarding the value of JV-related options.

We suggest that the choice of specific measures for uncertainty should go with the actual contexts where investment decisions are made by managers. For that purpose, research efforts must be directed to identify and measure more meaningful sources of uncertainty, which are relevant to key decision making at the appropriate unit of analysis. Specifically, country-level uncertainty would be less important than business level uncertainty from a manager’s standpoint if initial real options investment is expected to facilitate organizational learning to cope with endogenous uncertainty. In this sense, frequently used measures of uncertainty in recent studies should be reexamined carefully. For instance, in spite of its aforementioned advantages recognized in the real options literature as capturing ‘skedasticity’ or ‘volatility’ in a time trend associated with macro-economic factors including foreign exchange rates (e.g., Lee & Makhija, Reference Lee and Makhija2009a, Reference Lee and Makhija2009b), a GARCH model may not apply well in measuring features of uncertainty that directly affect managerial decisions at the firm level. More than often, the availability of sufficient past data for a time series estimation can limit the applicability of the GARCH model to theoretically meaningful or greater degree of uncertainty in the contexts relevant to real options arguments (e.g., novelty and hyper-uncertainty in entrepreneurship).

Hence, putting aside issues of data availability, we suggest that future real options research (1) use multiple measures for capturing uncertainty, including standard deviation, realized volatility, and/or perceived uncertainty by decision makers, that can be compared with GARCH for robustness checks, (2) investigate temporal aggregation issues with different intervals (e.g., monthly [vs.] weekly estimates), and (3) recognize and measure different sources of uncertainty more directly related to firm-level decisions (e.g., fluctuations in prices of intermediate goods instead of prices of general commodity or raw materials).

Correlation within and between differing types of uncertainty

In addition to measuring the form of uncertainty relevant for the real options investment, it is important to consider the correlations among different sources and forms of uncertainty. This point is made by Kogut and Kulatilaka (Reference Kogut and Kulatilaka1994b), who note the negative effects of potential correlation of uncertainty measures among countries on overall volatility and real options value. For instance, during the Asian economic crisis in 1997, at least five countries in the East Asian region of the world had significant unexpected plunges in the value of their currencies at approximately the same time (Grewal & Tansuhaj, Reference Grewal and Tansuhaj2001; Lee & Makhija, Reference Lee and Makhija2009a, Reference Lee and Makhija2009b). This case clearly shows that a relatively large region of the world, encompassing multiple countries, can have highly correlated uncertainty. In order to address this issue empirically, Belderbos and Zou (Reference Belderbos and Zou2009) and Chung et al. (Reference Chung, Lee, Beamish and Isobe2010) examination of Japanese FDI into Asian countries during the 1997 Asian economic crisis took into account the correlations of annual exchange rates of a host country of a foreign subsidiary with other host countries in which the parent firm also had subsidiaries. Similarly, the relationship between two countries in the European Union, such as Germany and France, is not expected to be the same as that of India and France. We therefore suggest, at the very least, the inclusion of a regional dummy for regions with high correlation in uncertainty to help address this correlation issue.

In addition to accounting for correlations among a given type of uncertainty, as in the examples above, correlations between different types of uncertainty can also be taken into consideration. For example, Goldberg and Kolstad (Reference Goldberg and Kolstad1995) suggest that MNEs should invest in a location characterized by high correlation between export demand and exchange rate shocks since producing in such locations helps to insulate MNEs from currency-related uncertainty. Such approaches will lead to refinement in the ways in which uncertainty is theoretically treated and empirically examined. As more than one type of uncertainty naturally coexist in the international context, such investigations will enrich the real options literature in IB.

Size and ownership of investment

While much of the real options literature relating to international investments has focused on small-sized investments, we believe there is need for further work substantiating the real options value of such investments. Although a small investment helps to reduce the problems of irreversible commitment, other side-effects with respect to the valuation and exercise of real options should also be considered. One such issue relates to the difference between an investment that has been minimized through a shared ownership stake and an investment that is wholly owned but purposefully limited. For example, Fisch (Reference Fisch2009a) found that for a sample of German MNEs’ foreign subsidiaries, a small-scaled unshared investment carries future decision rights to engage in more internationalization, whereas shared ownership level (i.e., joint venture) does not carry real options value, but instead affects the firm’s ability to control its investment consistent with internalization theory. In contrast, a study by Brouthers and Dikova (Reference Brouthers and Dikova2010) finds that real options theory does not at all apply to small-scaled investments. Since these findings are in contrast to conclusions of other IJV studies, the potential interplay between unshared and shared ownership level deserves further study in terms of their real options value.

It would also be worthwhile to further investigate the potentially contrasting effects of sharing equity for international investments. Researchers have stressed that shared ownership allows the firm to limit associated downside risk while preserving upside potential as the environment changes (Tong, Reuer, & Peng, Reference Tong, Reuer and Peng2008; Cuypers & Martin, Reference Cuypers and Martin2010). However, when a firm’s ownership share is high, it will limit the firm’s ability to benefit from such flexibility. In addition, foreign subsidiaries with shared ownership with other local firms make it difficult for headquarters to exert control over them and exercise options as necessary (Lee & Chung, Reference Li, James, Madhavan and Mahoney2007; Tong & Reuer, Reference Tong and Reuer2007). Such contrasting effects of IJVs have not been adequately considered in the literature.

Our review suggests that further work can also enhance our understanding with respect to switching options. In principle, MNEs’ international networks of subsidiaries provide strategic flexibility that facilitates an immediate response to downside risks. Firms with production facilities located in multiple countries can respond to adverse changes in any given country such as exchange rate volatility (Kogut & Kulatilaka, Reference Kogut and Kulatilaka1994b; Reuer & Leiblein, Reference Reuer and Leiblein2000) and increased political risks (Makhija, Reference Makhija1993). However, in reality production cannot be shifted elsewhere with the ease implied in the switching option perspective. Because MNEs’ operations involve investments that result in the ownership and operation of productive facilities, divesting foreign operations in times of economic crisis may not always be the best strategic option for MNEs. In the case of downside risks, such as economic crises, MNEs are more likely to continue producing and investing in a given location because investors’ horizons are typically long term and their deep involvement with the host economies after the investment is made (Lipsey, Reference Lipsey2001). In addition, the implementation of decisions to transfer production is not typically so clear-cut (Lee & Makhija, Reference Lee and Makhija2009a). There are significant transaction costs associated with the myriad of country-specific transactions in a given subsidiary, including those associated with suppliers, customers, distributors, and government agencies, among others (Hitt, Hoskisson, & Kim, Reference Hitt, Hoskisson and Kim1997). This makes it difficult to determine the actual costs of switching production from one location to another. In addition, the specific characteristics of the firm’s operations in different host countries determine how easily production can actually be transferred to an alternative location (Rangan, Reference Rangan1998; Lee & Makhija, Reference Lee and Makhija2009a). Production in different countries must be fairly similar in nature, otherwise the option benefits are outweighed by the costs of reconfiguring the factory and retraining workers. Indeed, abandoning investments with ease has not been documented by the empirical IB research. Thus, a deeper consideration of the conditions under which switching options are valuable for the firm will enrich the literature.

Portfolio or combination of options

While options such as portfolio and compound options may also exist, the IB literature has not considered these in any significant manner. Considering that firms often undertake multiple projects, their strategic decisions can be viewed as bundles of resource-investment alternatives or real options (Bowman & Hurry, Reference Bowman and Hurry1993). Indeed, research suggests that the value of a portfolio of real options can have super-additive or sub-additive properties, determined by the correlations of underlying assets, uncertainty types, and organizational constraints (Vassolo, Anand, & Folta, Reference Vassolo, Anand and Folta2004). For example, Anand, Oriani, and Vassalo (Reference Anand, Oriani and Vassolo2007) note that high technological uncertainty leads the value of the underlying assets to be negatively correlated, possibly requiring firms to have a wider portfolio of options to increase switching options value. In contrast, under high market uncertainty, firms will benefit from positively correlated underlying assets to increase growth options value. While these researchers highlight the contrasting effects of options within a portfolio of investments, others stress the interactions among different options embedded in a single investment, resulting in complementary or conflicting effects on real options value. For example, a study by Folta and O’Brien (Reference Folta and O’Brien2004) finds that the relative value of deferral and growth options within the same investment is influenced by separate conditions. While uncertainty levels up to the 94th percentile deter entry into a new industry, industry growth potential and preemptive advantages tend to enhance the value of growth options and thus shorten the time to enter. By the same token, Oriani and Sobrero (Reference Oriani and Sobrero2008) find that in the presence of cumulative technologies, deferral options may be suboptimal as they can lead to lock-out.

We believe that both lines of inquiry have tremendous scope for application in the international context. The value of an MNE’s overall portfolio of international real options investments is likely to be different from the aggregated value of each individual investment, since not all options provide value under the same conditions of uncertainty, and instead may reduce flexibility under some conditions. In this respect, options may compete with each other in some ways where the value of one type of option is negatively correlated with the value of another type of option in a portfolio, thereby reducing the overall value of the portfolio. In addition, despite the fact that researchers have noted that international investments can have more than one option – often stressing switching and growth options in this regard – virtually all prior empirical work has focused only on one option at a time. If multiple options embedded in the same investment have divergent effects, this approach is unlikely to depict a complete picture. Indeed, the unique characteristics of these two different types of real options create important tradeoffs. While growth options reflect a firm’s intention of continuing a given strategy, switching options underlie the desire to adaptively change its strategy (Bowman & Hurry, Reference Bowman and Hurry1993). We believe that these contrasting aspects and interactions between different options provide important new research opportunities for understanding the real options value of international investments.

Valuation of real options

There is currently a dearth of formal valuation research, which measures the primary attributes of the Black–Scholes model such as exercise price, value of underlying assets, and maturity relative to uncertainty. Even though some scholars (e.g., Folta, Reference Folta1998; Folta & Miller, Reference Folta and Miller2002; Folta & O’Brien, Reference Folta and O’Brien2004) have tried to measure exercise price in the context of governance choices, we find that there has been relatively little applied research in IB examining the impact of other attributes (i.e., maturity, expected cash flow, and exercise price) of the Black–Scholes model. Instead, early real options studies have adopted real options logic to explain managerial decisions in international investments or technology choices – and more recently, entrepreneurial actions (e.g., Lee, Peng, & Barney, Reference Li, James, Madhavan and Mahoney2007) – in the face of uncertainty. In this sense, management scholars have been more interested in measuring uncertainty and applying the analogy of real options, neglecting other dimensions of the Black–Scholes model. As a general rule, the absence of empirical studies fully examining critical aspects of real options value and the relationships predicted by the theory, particularly maturity or exercise price and option value in real options theory, represents a research opportunity for IB scholars.

Costs of real options

Real options theorists are also concerned about whether multinationality is always value-enhancing, since some have assumed that firms can shift production from one subsidiary to other subsidiaries when needed and the costs of shifting options are low (Reuer & Leiblein, Reference Reuer and Leiblein2000; Tong & Reuer, Reference Tong and Reuer2007). However, due to some obstacles to realizing the benefits of multinational operations, multinational flexibility may not be achieved automatically or efficiently as breadth increases. Managing a highly dispersed set of international investments imposes higher coordination costs on the firm. These costs are likely to increase the uncertainty of future earnings and thus undermine the total value of a firm’s growth potential, including operating flexibility (Doukas & Pantzalis, Reference Doukas and Pantzalis2003). Likewise, the burden associated with multiple transactions among geographically diverse units increase transaction and governance costs (Allen & Pantzalis, Reference Allen and Pantzalis1996; Tong & Reuer, Reference Tong and Reuer2007), which lead to organizational inefficiencies (Lu & Beamish 2004), consistent with predictions of transaction costs economics. Further investigation of the value and costs associated with MNEs’ international networks will provide important insights for better understanding the tradeoffs that may exist in this regard. Furthermore, the IB literature can benefit from comparisons of the costs of different types of options. For instance, Chi and Seth (Reference Chi and Seth2009) report that the bargaining costs arising from divergent objectives of IJV partners can hamper MNEs’ ability to respond to future environmental changes and reduce the flexibility value of an IJV. In this sense, future studies can consider the difference between the cost of coordinating partners’ effort in a joint venture and the cost of coordination associated with an acquisition mode of foreign market entry.

Accounting for firm heterogeneity

Theories in IB and strategic management strongly suggest that capability differences among firms lead to significant variation in firm decisions and outcomes, as well as cause them to be differentially successful in the marketplace (Barney, 1986, 1991; Buckley & Casson, Reference Buckley and Casson1998). Firms vary in their ability to adapt to new foreign environments (Johanson & Vahlne, 1977), recognize new information and engage in innovation (Cohen & Levinthal, 1990), work with alliance partners (Contractor & Lorange, 1988), and engage in learning (Makhija & Ganesh, 1997). Such capabilities can also influence firms’ ability to structure and exercise options effectively. Nonetheless, the majority of the ROT literature as applied to international investments has not focused on the role of heterogeneity or asymmetry among firms, which can influence, for instance, behavioral choices relating to the tradeoff between strategic commitment and flexibility or in timing investments appropriately in an uncertain market.

Heterogeneity in capabilities may lead different firms facing the same opportunity and uncertainty to display different investment choices in relation to option creation or exercise (Tong & Reuer, Reference Tong and Reuer2006; Tong, Reuer, & Peng, Reference Tong, Reuer and Peng2008; Cuypers & Martin, Reference Cuypers and Martin2010). It is important to take into account such asymmetric responses to exogenous shocks stemming from variances in firms’ resources and capabilities when examining the effects of uncertainty on real options value. For instance, using a data set of Thai firms, Grewal and Tansuhaj (Reference Grewal and Tansuhaj2001) discovered that firms’ organizational capabilities had differential influences on their performance during the Asian economic crisis in late 1990s. They find that greater market orientation of a firm, referring to its ability to gather and use market-related information, reduced its performance after the crisis, whereas greater strategic flexibility, pertaining to its ability to proactively or reactively respond to market threats and opportunities, positively influenced performance. They argue that market orientation is a capability that is not as useful under the conditions of flux characterizing an economic crisis, whereas firms’ capability for adapting to rapidly changing conditions is particularly relevant in this regard.

It is important to recognize that firms have differential cost structures that can also influence the management of their real options. Even though costs are assumed to be symmetric or zero in early real option game models, accounting for asymmetrical costs enables identification of different strategic equilibrium such that the lowest-cost firm would enter first or acquire growth options. For instance, Pawlina and Kort (Reference Pawlina and Kort2006) examine the impact of investment cost asymmetry on the value and exercise strategies of firms under imperfect competition and show that a marginal increase in the investment cost for the firm with the cost disadvantage can enhance the firm’s own value while the presence of identical firms can result in a socially less desirable outcome than a cost asymmetric situation. More generally, non-standard real option game models (Azevedo & Paxson, Reference Azevedo and Paxson2014) relax several assumptions and constraints on firm heterogeneity and incorporate ex ante and ex post asymmetries in information, cost, and capability. For example, Smit and Trigeorgis (Reference Smit and Trigeorgis2004) consider the rate of learning as firm specific and asymmetric between duopoly firms who make a strategic R&D investment in an innovative new production process or invest earlier in production capacity reducing future production costs.

Similarly, Kong and Kwok (Reference Kong and Kwok2007) model ex ante asymmetries on both the sunk costs and revenue flows in duopoly and investigate the value of real options and strategic interaction of investment decisions. With asymmetry on both the sunk costs and revenue flows, they show that simultaneous entry or preemption by the high-cost firm is possible especially when the preemptive thresholds of the two firms coincide. This phenomenon is called ‘non-zero probability of mistake’ in the real options literature. In comparison, Hsu and Lambrecht (Reference Hsu and Lambrecht2007) focus on the information asymmetry between a new entrant and the incumbent where the new entrant has complete information about the incumbent, but the incumbent does not know the precise value of the new entrant’s investment costs. They find that even a small probability of being preempted gives the informationally disadvantaged firm an incentive to invest at the breakeven point where it is indifferent between investing and being preempted.

This body of work suggests that a wide set of asymmetries between firms can have important and interesting influences on their real options strategies. Since the international context is even more complex than domestic contexts, with greater potential for seeing capability differences among firms across national contexts and more variation in competitive conditions, it is vital to consider how these factors interact with international sources of uncertainty in a way that influences the value of real options investments. Research that incorporates these elements can help us to understand in more detail how international real options investments should be managed.

Accounting for variations among managers

Differences in managerial capability may also affect the firm’s ability to manage its real option investments. For example, Barnett (Reference Barnett2008), Coff and Laverty (Reference Coff and Laverty2008), and Schwartz and Trigeorgies (Reference Schwartz and Trigeorgis2001) note that the theoretical value of real options approach may not be realized in practice if managers, in pursuing their own interests, misuse their discretion and do not follow the optimal exercise policies that are often implicit in option valuation. By the same token, Barnett (Reference Barnett2008) points out that the costs and organizational complexities involved in creating and holding multiple options are part of the price of the option, yet lack of attention or commitment are often overlooked as drawbacks to maintaining a portfolio of options. More recently, Driouchi and Bennett (Reference Driouchi and Bennett2010) found that MNEs that have high managerial awareness about their real options are able to reduce their downside risk through multinationality and organizational slack, but MNEs without such awareness are not fully able to benefit from their switching options in multinational operations. These findings suggest the importance of drawing from the resource-based view and agency theory in order to take into account firm and managerial capabilities in exercising real options.

Since perceiving and responding to exogenous uncertainty and opportunities significantly affects firm value and performance, managers’ ability to recognize and select opportunities plays an important role (Barnett, Reference Barnett2008). However, managers cannot gather all possible information from their environment due to limited attention and information processing capacities (Cuypers & Martin, Reference Cuypers and Martin2007). As a result, managers are not able to make completely accurate representations of their complex environments on which their decisions and actions are based. In light of this, we expect that decision makers’ subjective perception of uncertainty, and thereby their valuation of options, is dependent on their incentives, abilities, and experiences from prior investments. It is thus critical that future research take into account organizational and psychological factors that may complicate the application of real options logic and point to the proper boundaries of real options theory (Adner & Levinthal, Reference Adner and Levinthal2004). Decision-making theories encompassing bounded rationality may help to inform this line of inquiry.

Examination of firms’ international investments in fact provides a number of important opportunities for studying managerial capabilities with respect to decisions under uncertainty. Since MNEs vary significantly in the number of international investments they have, it becomes possible to study how this affects managers’ decision making, particularly with respect to how managers deal with information overload and complexity in making decisions about the structuring and exercise of real options. For example, we may find that the complexity ensuing from investments across a greater set of diverse national contexts results in more mistakes in structuring and exercising options by managers than when investments are in fewer countries, or that the ability to exercise more options (from more investments) has the greater beneficial effect. Another interesting question stems from the location of the decision maker. While scholars have tended to assume that decision making vis-à-vis these investments is concentrated at headquarters, MNEs may also relegate decisions to local managers for their international investments. It may be that local managers make better decisions regarding the exercise of options, or instead, that their localized knowledge is inadequate for decisions relating to the firm as a whole. In this regard, cultural influences on managers’ decision making can also be considered. For example, collectivism can influence how information is gathered and shared among managers, while variations in risk propensity may influence how and when options are exercised. Since relatively little work has been done on these issues, such investigations will not only help to understand the role of management for international real options investments, but will also shed light on the management of other types of investments.

Sub-optimality of options exercise

Despite theoretical predictions that real options can be exercised in an appropriate amount of time, some researchers have pointed out the risk of inappropriately prolonged exercise (McGrath, 1999; Adner & Levinthal, Reference Adner and Levinthal2004). The phenomenon of such prolonged exercise is closely related to the notion of escalating commitment in organization theory. More generally, the timing and conditions of options exercise is closely related to the boundary conditions of real options theory. Recent debate on sub-optimality of options exercise is triggered by a growing realization that even though the ability to wait and see until uncertainty resolution drives real options value, the question remains as to how long any given option can and should be held.

This concern is further ignited by Adner and Levinthal (Reference Adner and Levinthal2004) who argued that well-structured abandonment (i.e., a pre-specified maturity date after which the option expires) is a crucial condition of any kind of options investment, be it financial or real, and proposed that it is necessary to distinguish between ‘investments with real options’ and ‘real options investments.’ They further stressed that real options are not only a matter of investment implementation, but also a theoretical point of view about retaining flexibility based on well-structured abandonment policies. They warned of ‘option traps’ that hinder the abandonment of opportunities from, for example, psychological biases regarding sunk costs and escalating commitment. In response, McGrath, Ferrier, and Mendelow (Reference McGrath, Ferrier and Mendelow2004) criticized Adner and Levinthal’s arguments as restricting the boundaries of real options reasoning. Instead, they suggested a more extended view of flexibility, which in fact allows for flexible adjustment with path-dependent strategic choice and changes. Zardkoohi (Reference Zardkoohi2004) agreed with McGrath, Ferrier, and Mendelow’s suggestion that Adner and Levinthal’s approach to real options investment may reduce the value of real options theory for strategic decision making.