Settling the debate on multinational capital structure using the CEPR measure

Portfolio theory suggests that because of diversification benefits, multinational corporations (MNCs) should have lower risk and therefore could have more debt. Empirical studies, however, have repeatedly shown that MNCs from the US face higher risks and have lower debt levels. Burgman (1996) suggests that agency costs as well as political and exchange rate risks are the explanation. Kwok and Reeb (2000) explain this puzzle, presenting an upstream-downstream hypothesis suggesting that MNCs from emerging markets reduce their risk by going international (they go to safer markets), while firms from developed countries increase their risk by going abroad (they go to riskier markets). By introducing a new measure of Country Export Partner Risk (CEPR), we show that the weighted average risk level of a country's export trading partners is negatively related to the leverage of its multinationals, thus confirming the upstream-downstream hypothesis. Furthermore, once controlling for CEPR, we find that the multinationality of the firm is positively related to leverage, thus lending support to the traditional diversification argument. Our findings, therefore, help settle the debate between these two opposing streams of multinational capital structure literature.