Exchange Rate Risk and the Impact of Regret on Trade

Abstract

This paper examines the behavior of the regret-averse multinational 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 multinational firm optimally produces less, sells more domestically, and export less abroad under uncertainty than under certainty holds if the multinational firm is not too regret averse. Using a simple 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 multinational firm is sufficiently regret averse and the low spot exchange rate is very likely to prevail.