Abstract
This paper examines the boundaries of real options logic, with an application to joint ventures (JVs). We distinguish between forms of uncertainty that are resolved endogenously and those that are resolved exogenously, and theorize that only exogenous uncertainty will have the impact predicted by real options theory on a foreign investor's choice of how large an equity share to take in a JV. We theorize that macroeconomic and institutional variables generate exogenous uncertainty whereas, by contrast, cultural distance and choices pertaining to corporate scope and product or process development activities involve endogenous sources of uncertainty that investors can both assess and act upon without having to “wait and see”. Using a sample of 6472 Sino-foreign JVs, we find support for our predictions. We discuss and implement proper methods to test for the existence of null effects, as is relevant to establish the boundaries of a theory such as real options theory. We draw implications for research and practice on JVs – specifically equity share decisions, which deserve more attention – and real options, including suitable uses and desirable extensions of the concept.
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Notes
The approaches that have been used in the few existing studies investigating the distribution of JV ownership among partners are transaction cost economics (Chen et al., 2002; Delios & Beamish, 1999; Gatignon & Anderson, 1988), agency theory (Chi & Roehl, 1997; Nakamura & Yeung, 1994) and the bargaining perspective (Blodgett, 1991; Fagre and Wells, 1982). However, these studies have yielded mixed results regarding the role of (behavioral) uncertainty in the equity distribution of JVs. For a detailed review of this literature, see Cuypers and Martin (2007).
The concept of uncertainty used in option theory is actually one of risk in the sense of Knight (1921), in that options pricing models assume that it is possible to specify the probability distribution of future asset values. Nevertheless, we follow the extant use of terminology in referring to this as “uncertainty”.
In the case of exogenous uncertainty the firm will wait for information about how the exogenous source of uncertainty has evolved and subsequently take action, that is, decide whether to strike, hold onto or abandon the option. In a broad sense this can also be seen as learning. However, contrary to learning in the case of endogenously resolved uncertainty, the firm cannot determine the pace of information revelation, nor can it influence its outcomes. “Learning” amidst exogenous uncertainty thus simply represents the passive receipt of updated information. It does not represent the systematic, forward-looking accumulation of experience or the proactive development of causal insight that is normally associated with organizational learning (Fiol & Lyles, 1985).
For simplicity of exposition, we treat the foreign partner as the call option holder. This is consistent with the existing literature (e.g., Reuer & Tong, 2005). We will discuss why this assumption is all the more valid in our empirical setting, that is, China, when we describe our sample below. In some other empirical settings it may be less clear who is the call option holder.
MOFTEC was formerly known as the Ministry of Foreign Economic Relations and Trade (MOFERT), and is currently known as the Ministry of Commerce of the People's Republic of China (MOFCOM).
Pan (2002) also looks at JVs established between 1979 and 1996. Other studies use a subset of our sample. Pan's (1996) sample covers the 1979–1992 period; Chadee and Qiu (2001) look at 1992–1995; and Chadee et al. (2003) study JVs established between 1984 and 1996.
Deng Xiaoping's reforms were summed up in the “Four Modernizations” of agriculture, industry, science and technology and the military. The focus was on knowledge transfer from the West. The CCP's initial view was that this could best be achieved by setting up joint ventures with foreign partners. Therefore all alternative investment modes were prohibited except for a few exceptions (Almanac of Foreign Economic Relations and Trade of China, various issues).
Whatever the letter of the law, contracts may be imperfectly enforceable in the presence of weak institutions. For instance, in the context of the Brazilian telecommunication industry, Perkins, Morck, and Yeung (2008) found that local partners may use pyramidal ownership schemes, and used local institutions to take advantage of foreign partners. Our fieldwork does not suggest that this is as much of an issue in China. This may partly explain why China has been so successful at attracting foreign direct investment, including Sino-foreign JVs. As Fan, Morck, Xu, and Yeung (2007: 25) put it: “Ultimately, China may well provide a better institutional environment for FDI operations than for domestic operations – large or small, state controlled or privately run. If China, more than other countries, favors FDI in this way, it might well receive an elevated FDI inflow”.
The Euromoney index is available in its current format only from 1982 onwards. An alternative format, albeit with similar interpretation, was reported for the earlier years in our study period. We transformed the index for the earlier of our sample years to get consistent scores that go back to 1979. Excluding the observations from 1979 to 1981 or using alternative methods to extrapolate does not materially change our results. We opted to keep these observations to have a more complete and representative sample.
Shenzhen, Zhuhai and Shantou in Guangdong Province, Xiamen in Fujian Province, and all of Hainan province.
Dalian, Qinhuangdao, Tianjin, Yantai, Qingdao, Lianyungang, Nantong, Shanghai, Ningbo, Wenzhou, Fuzhou, Guangzhou, Zhanjiang and Beihai.
As an alternative measure of institutional uncertainty, we used the component of the Economic Freedom of the World index that captures the level of uncertainty resulting from a country's institutional framework. This measure is published annually by the Fraser Institute, and varies over time rather than between different geographical areas within China. Our results remain robust. However, using this alternative measure resulted in moderate levels of collinearity, which is especially undesirable when testing multiple hypotheses. Therefore we used the location-based variable described above instead.
Exchange rate data are from various annual issues of the World Currency Yearbook, Pick's Currency Yearbook and the IMF's Annual Report on Exchange Rate Arrangements and Exchange Restrictions.
To test the robustness of our results, we used the 18-month volatility of the parallel rate (again the common time frame) as an alternative measure of exchange rate uncertainty. The results were consistent with those reported below.
Our sample covers (parts of) the fifth (1976–1980), sixth (1981–1985), seventh (1986–1990) and eighth (1991–1996) plans. The period effects are lagged by one year because these plans were usually announced at the end of the year. Thus fixed effects represent the periods 1979–1981, 1982–1986 and so on.
Our model comprises two levels: JV and home country. Such a model is also referred to as a tobit model with double censoring and random effects. Here, the random effects are for home countries.
Several scholars have argued that JVs in which one partner has a very dominant controlling stake can be better considered as wholly owned subsidiaries (e.g., Hennart, 1991). Therefore, to test the robustness of our results, we also specified several models with different limit values of ownership – such as upper limits of 90% (e.g., Hennart, 1991) and 95% (e.g., Hennart & Larimo, 1998; Lu, 2002) ownership. Our results were robust to these alternative tobit specifications.
We are grateful to an anonymous reviewer and the Associate Editor for pointing out this issue and putting us on the path towards using the alternatives below.
In the language of power analysis, α is the significance criterion, that is, the “level of significance” as commonly used to evaluate (non-null) hypotheses. β is the probability of rejecting the null hypothesis when it is in fact false, that is, of making a type II error. The value we set for these parameters is more conservative than those used by Lane et al. (1998), for example. Note that β as referred to in this paragraph is a parameter for the power calculations, not to be confused with the β coefficient estimates from regression analyses as discussed elsewhere in the paper.
A stepwise approach adding each hypothesized variable separately does not substantively change the results.
We generated the posterior distributions using uninformative priors and the Gibbs sampler. This involves sampling sequentially from all relevant conditional distributions over a large number of iterations. We made 100,000 draws from a single continuous Gibbs chain, of which the first 20,000 draws are used as a “burn in” period and subsequently discarded. Unfortunately, existing Bayesian software is limited in that it does not allow for random effects and cannot incorporate left-censoring and right-censoring simultaneously. The replication is therefore imperfect. Nevertheless, our results are very similar to those obtained using the conventional (non-Bayesian) tobit model.
In addition, we replicated the commonly used if statistically problematic use of post hoc power analysis to test the null Hypotheses 4–6. The results, available from the authors, again show that the effects of the endogenously resolved variables do not differ from zero.
We are grateful to an anonymous reviewer and the Associate Editor for pointing out these research opportunities.
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Acknowledgements
We thank Jérémie Lefebvre, Kent Miller, Jeff Reuer, Anju Seth, and the Associate Editor Anand Swaminathan and three anonymous reviewers for insightful comments. We are especially grateful to Youtha Cuypers for her many helpful suggestions. The paper also benefited from presentations at City University of Hong Kong, EM Lyon, ESMT Berlin, Georgia Tech, Hong Kong University of Science and Technology, Michigan State University, National University of Singapore, Singapore Management University, SUNY Buffalo, University of Queensland, University of Amsterdam, Warwick Business School, and Western Washington University, and at conferences at IESE, LBS and Radboud University Nijmegen. Any remaining errors are solely ours.
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Accepted by Anand Swaminathan, Area Editor, 15 December 2008. This paper has been with the authors for two revisions.
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Cuypers, I., Martin, X. What makes and what does not make a real option? A study of equity shares in international joint ventures. J Int Bus Stud 41, 47–69 (2010). https://doi.org/10.1057/jibs.2009.17
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DOI: https://doi.org/10.1057/jibs.2009.17