Academic journal article Multinational Business Review

A Commentary on Risk Reduction by Geographic Diversification

Academic journal article Multinational Business Review

A Commentary on Risk Reduction by Geographic Diversification

Article excerpt

Abstract:

The relationship between multinationality and value is still one of the most fundamental questions in IB research. Gande, Schenzler, and Senbet (2009) claim to have found empirical evidence for the incomplete capital markets theory (ICMT), which stipulates that investors value corporate multinationality due to its risk-reducing effect. We show here that their findings do not support the hypothesis that investors value geographical diversification at the firm level because of its risk reducing effect. Further, a review of extant research shows that empirical results concerning the valuation impact of the risk-reducing effect of geographical diversification at the firm level have to be regarded with caution due to conceptual and methodological inconsistencies. Consequently, this paper proposes several methodological refinements.

Keywords: Multinationality, performance, geographical diversification, risk reduction, incomplete capital markets theory.

INTRODUCTION

The relationship between multinationality and firm value is one of the fundamental and most fascinating questions in international business research (Dastidar 2009; Peng 2004; Verbeke and Brugman 2009). Yet the results of previous studies are inconclusive or even contradictory. Whereas some authors argue that multinationality increases value (Bodnar,Tang, and Weintrop 2003), others come to the conclusion that multinationality has a negative effect on value (Click and Harrison 2000; Denis, Denis, and Yost 2002). Others find that multinationality leads to an increase in value if certain conditions are fulfilled and does not lead to value enhancement or even reduces value in the absence of these conditions (Berry 2006; Markides and Ittner 1994; Mishra and Gobeli 1998; Morck and Yeung 1991; Pantzalis 2001).

Given these contradictory results, the demand for clarifying research regarding the valuation impact of corporate multinationality is still substantial. A theoretically elaborated approach to explain the valuation impact of corporate multinationality is based on the risk-reducing effect of geographical diversification at the firm level and is termed the incomplete capital markets theory (ICMT). This approach has been developed by scholars like Rugman (1976, 1979) and Erranza and Senbet (1981, 1984). Since then the idea of the ICMT has been questioned in a number of studies (Morck and Yeung 1991; Markides and Ittner 1994). A recent contribution in the Journal of International Business Studies - Gande, Schenzler, and Senbet (2009) - takes up the concept of the ICMT and claims to have found empirical evidence regarding the "financial dimension of global diversification," i.e., the ICMT. In short, Gande, Schenzler, and Senbet claim to have found evidence that investors value corporate geographical diversification (besides other aspects) due to its risk-reducing effect.

In this paper the following statements are developed:

1. The findings of Gande, Schenzler, and Senbet are not appropriate to support the hypothesis that investors value global diversification at the firm level because of its risk-reducing effect.

2. Due to conceptual and methodological shortcomings, extant research only provides questionable empirical results concerning the valuation impact of the risk-reducing effect of global diversification at the firm level.

THE INCOMPLETE CAPITAL MARKETS THEORY

The theoretical argument of the ICMT rests on the findings of portfolio theory that investing into imperfectly correlated securities (i.e., diversification) leads to efficiency gains (lower risk) compared with investing in one kind of security or investing in perfectly positively correlated securities (i.e., concentration). Capital market research has empirically substantiated that national capital markets are not perfectly correlated (Grubel and Fadner 1971; Kaplanis 1988; Longin and Solnik 1995; Rugman 1979). Hence, investing in securities from different countries leads to a reduction of risk and, therefore, proves to be beneficial for the investor. …

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