The role of multinational production in a risky environment

The crucial difference between Foreign Direct Investment (FDI) and other international financial flows is that the former involves technology flows across countries. In the presence of country-specific shocks, these flows not only alter the distribution of output across countries, but also across different states of nature. This paper introduces FDI simultaneously as a portfolio and technology flow in a risky environment. We find that multinational activities improve the scope for international risk diversification even in world with complete international financial markets. Multinational firms have incentives to locate affiliates in countries with business cycles least correlated with world risk. In doing so, they reshape the patterns of world risk and improve the scope for international risk diversification. A calibration exercise for OECD countries suggests that multinational activities reduces the consumption risk premium by 5% beyond the diversification opportunities provided by complete financial markets.