Abstract
This paper examines the behavior of the regret-averse firm under exchange rate uncertainty. Regret-averse preferences are characterized by a modified utility function that includes disutility from having chosen ex-post suboptimal alternatives. We show that the conventional results that the firm optimally produces less, sells more domestically, and export less abroad under uncertainty than under certainty holds if the firm is not too regret-averse. Using a binary model wherein the random spot exchange rate can take on either a low value or a high value with positive probability, we show that the conventional results may not hold, particularly when the firm is sufficiently regret-averse and the low spot exchange rate is very likely to prevail.
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Notes
1 We assume that production takes place at home.
2 In our model, regret is driven by the lack of flexibility that the firm can react to new information, which is in stark contrast to the real options approach.
4 Our results also apply when the firm cannot sell domestically and has to export to the foreign country only, i.e., the firm is an exporting firm.
5 The strict convexity of the cost function reflects the fact that the firm’s production technology exhibits decreasing returns to scale. Our qualitative results remain intact if the firm can produce the commodity in both the home and foreign countries according to the respective deterministic cost functions.
7 Throughout the paper, random variables have a tilde (∼) while their realizations do not.
8 An alternative way to model the exchange rate uncertainty is to apply the concept of information systems that are conditional cumulative distribution functions over a set of signals imperfectly correlated with \(\tilde {S}\) (Broll et al. 2014).
9Braun and Muermann (2004) and Wong (2011, 2012) consider a regret function that depends on the difference between the utility level of the actual home currency profit and that of the maximum home currency profit, U(πmax)−U(π). Since such a specification is simply a monotonic transformation of ours, none of the qualitative results are affected if we adopt this alternative approach (see also Wong 2014).
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We would like to thank George Tavlas (the editor), Bernhard Eckwert, and two anonymous referees for their very helpful comments and suggestions.
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Broll, U., Welzel, P. & Wong, K.P. Exchange Rate Risk and the Impact of Regret on Trade. Open Econ Rev 26, 109–119 (2015). https://doi.org/10.1007/s11079-014-9321-0
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DOI: https://doi.org/10.1007/s11079-014-9321-0