Using Demand Systems to Evaluate Risky Projects: An Application to the Automobile Industry

Abstract

We examine how the risk-return profiles of carmakers BMW and Porsche depend on whether car models are produced in the US or Europe. Using data from the US car market we combine a demand system for differentiated products with counterfactual paths to macroeconomic variables. We let prices and quantities respond to counterfactual values of exchange rates and consumer confidence. This allows us to generate counterfactual profit distributions at different horizons for alternative domestic and foreign production configurations. For plausible costs of building a plant, production in the US is attractive for BMW, but not for Porsche.

Keywords: Exchange rate exposure, net present value, certainty equivalent valuation, macroeconomic exposure, operational hedging, natural hedging, demand for cars

JEL Classification: F23, G32, L16, L62