2017-17
The Effect of Corporate International
Diversification on Firm Risk

Charee Kwak

The Effect of Corporate International
Diversification on Firm Risk

Charee Kwak
Graduate School of Business Administration, Kobe University

Abstract
This study investigates the relation between corporate international diversificationand firm risk using a sample of listed Japanese firms. Diversification benefits obtainedby operating in multiple markets which are not perfectly correlated can decrease risk,
according to portfolio theory. However, additional risk factors of foreign expansion
including currency risk, political risk, and greater agency costs may increase risks ofmultinational firms. Previous studies also report conflicting results, risk-increasing andrisk-decreasing. The results of this study present that corporate international
diversification increases systematic, idiosyncratic, and total risk. This indicates thatshareholders consider overseas expansion of Japanese firms as risk-increasing and thecost of capital of Japanese multinationals becomes higher because of the increase in risk.

11. Introduction
Firm risk is an important factor in investment decision making process, because it
implies the uncertainty regarding the expected returns on the investment. It is also adeterminant of the firm’s cost of capital, which indicates required return of investors.
Higher risk causes an increase in required returns due to risk premium for higher risk,
resulting in increasing of cost of capital. Therefore, knowledge of the level of risk would
be crucial for firms that invest overseas. However, the relation between corporate
international diversification and firm risk has not been completely clarified. The
expected effect of overseas operations on risk is conflicting based on theoreticalbackground. The empirical results of previous studies are also inconsistent.
In the portfolio theory, corporate international diversification can reduce firm risk.
Because multinational firms are highly diversified compared to domestic firms, theywould get risk-reducing effect comparable with diversification benefits which are
obtainedbyholdinganefficiently

diversified

portfolio.

Rugman(1976)

andShapiro(1978) argue that cash flows from various markets correlated imperfectly
generate the advantage of risk reduction. The results of some empirical studies are
consistent with their argument and present that overseas activities is associated withlower firm risk (e.g., Agmon and Lessard, 1977; Fatemi, 1984).
However, multinational firms may experience a greater firm risk owing to additionalrisk factors accompanied by foreign expansion. Their operations in foreign markets are
exposed to various risks such as exchange risk, political risk, an increase in agency costs,
and information asymmetry between parent and foreign subsidiaries. As a result, theserisks cause an increase in firm risk. Some previous studies support this view andsuggest that international operations are positively related to risk (e.g., Reeb et al.,
1998; Olibe et al., 2008).
As discussed above, there are inconsistent results on corporate international
diversification may have conflicting effects on firm risk, risk-increasing andrisk-decreasing. Thus, the effect of corporate international diversification on risk
depends on the net of two sides of effect. Moreover, most of previous studies use samplesof American or European firms, thus, it is hard to find the research on case of Japanesefirms. Despite to their active foreign expansions, there is little empirical evidence ofinternational diversification of Japanese firms as compared to that of American orEuropean firms. Therefore, this study explores the relation between corporate
international diversification and firm risk with a sample of listed Japanese firms. Thisaims to obtain the empirical implication of the impacts of foreign expansion on risk for2managers and investors of Japanese firms. Moreover, the result of this study would
have importance in terms of cost of capital. In recent, the importance of cost of capitalhas received considerable attention in Japan. The Ito Review (2014)1 suggests thatfirms should pursue sufficient earnings that dominate their cost of capital forsustainable growth. Firms need to perceive their cost of capital exactly when they
establish their earnings goal. This study aims to investigate the relation between
corporate international diversification and the level of cost of capital by examining how
foreign expansion of Japanese firms influences their risk.
In empirical analyses, this study considers three types of risk, which are systematicrisk, idiosyncratic risk, and total risk. Most previous studies on the relation between
international diversification and risk have focused on systematic risk, because
idiosyncratic risk is expected to be eliminated through diversification under the Capital
Asset Pricing Model (hereafter, CAPM). However, some research suggests that
idiosyncratic risk is not fully diversified owing to market imperfections and, thus,
influences stock returns significantly (e.g., Merton, 1987; Malkiel and Xu, 2002; Ang etal., 2009). If idiosyncratic risk is not eliminated by international diversification, it
would affect total risk and the cost of capital as well. Thus, this study investigates theeffect overseas business activities on each risk measure, considering idiosyncratic risk
with other two risks. The ratio of foreign sales and assets are used as proxies for the
degree of international diversification. .
Regression results of this study show that corporate international diversification
increases firm risk. International diversification measures are positively associatedwith systematic risk, idiosyncratic risk, and total risk, after controlling for other
determinants of firm risk. These results also indicate that shareholders of Japanesefirms assume that foreign expansion increases risk of the firm. In addition, the cost ofcapital becomes higher as firm risk increases. Therefore, firms diversified
internationally should fully understand the increased risk involved in their foreign
expansion.
The remainder of this study is organized as follows. Chapter 2 introduces theoreticalbackgrounds for this research. Then, Chapter 3 reviews the literature and establishes
It indicates the final report that summarizes the results of the discussion of the“Competitiveness and Incentives for Sustainable Growth: Building Favorable
Relationships between Companies and Investors” project by the Ministry of Economy,
Trade and Industry (METI) in Japan. The report contains recommendations withrespect to the issues companies face in seeking to increase corporate value and generate
on-going growth via investor dialogue and capital procurement. As the project waschaired by Professor Kunio Ito, Graduate School of Commerce and Management,
Hitotsubashi University, the final report is known as the Ito Review.
13

hypothesis. Chapter 4 describes the sample, variables and the method for empiricalanalysis and Chapter 5 presents the results of regression. Finally, Chapter 6 draws
conclusions.

2. Theoretical Background2.1. Corporate international diversification and risk
Corporate international diversification has conflicting effects on firm risk. Previous
literature suggests that firms can obtain several benefits from multinational operations
that contribute a reduction in their risk. However, foreign expansion requires additionalcosts which may increase firm risk. Hereafter, I introduce the benefits and costs related
to the effect of overseas activities on firm risk.
Some advantages of international diversification would decrease risk of firms withforeign expansion. First, according to the argument of portfolio theory, multinational
operations can generate diversification benefit. The theory suggests that one can reducerisk of portfolio by combining assets, returns of which are not perfectly correlated. Dueto this effect, internationally diversified firms are able to get such diversification
benefits. Indeed, operations in multiple markets, where are imperfectly correlated
increase earnings stability (Rugman, 1976). The correlation between earnings ofmultinational firms and domestic markets decreases as the firms become morediversified internationally, owing to cash flows generated by those multiple markets,(Shapiro, 1978). Especially, under the circumstance where the barriers of international
capital flow exist, investors can indirectly diversify their portfolios by investing
multinational firms (Agmon and Lessard, 1977). In addition, business activities
performed in multiple markets may increase the firm’s operational flexibility anddecrease the probability of bankruptcy, thereby reducing its riskiness (Michel andShaked, 1986; Bodnar et al., 2003).
On the contrary, firms expanding their operations internationally confront withvarious costs that may increase their risk. Multinational firms are exposed to currency
risk, because their cash flows are influenced by changes in exchange rates (Reeb et al.,1998). Differences between home and host countries in political regulations and cultural
practices can be also significant determinants of increased risk by foreign expansion. If
multinational firms are not informed enough about their host countries compared to
local firms, riskiness of foreign expansion becomes larger. In addition, geographical4distance and difference in languages would make it difficult to monitor managers inforeign subsidiaries. Thus, information asymmetry between parent and foreignsubsidiaries may increase as firms become more diversified internationally (Lee andKwok, 1988). Moreover, greater complexity in operations of multinational firms is likely
to exacerbate agency problem.
To summarize the discussion, the effects of corporate international diversification on
firm risk are inconsistent. Business activities in multiple markets enable firms to takediversification benefits that decrease their riskiness. However, foreign expansion
requires additional costs such as currency risk, political risk, increased agency costs andinformation asymmetry between parent and foreign subsidiaries. Thus, whether
corporate international diversification is risk-decreasing or risk-increasing isdetermined by the net of those two effects.
2.2. Various types of risk
Modern finance theory on asset pricing evaluates the risk of certain asset by dividing
it into two parts, systematic and idiosyncratic risk. They have different characteristics
and implication.
Systematic risk refers to market risk inherent in the economy and is not diversified
with market portfolio. In the CAPM, the systematic risk is represented as beta (β) thatmeans the sensitivity of the expected returns of individual asset to that of the market
portfolio. The definition of beta is as follows:・
whereis the correlation coefficient between security i and the market portfolio;

is the standard deviation of returns of security i;is the standard deviation of themarket returns. As seen in the equation, beta is determined byand. Therefore,systematic risk of an asset is positively related with the risk of the asset and thecorrelation between the asset and the market.
Contrary to the systematic risk, idiosyncratic risk is defined as the risk which can be
mitigated by diversifying investment portfolio. It is also called firm-specific risk,
because it influences the firm at the microeconomic level and has less or no correlation
with market risk. Whether idiosyncratic risk should be priced is ambiguous. The
traditional CAPM approach, based on the assumption that all investors hold the market
portfolio in equilibrium, argues that idiosyncratic risk should not be incorporated into
5

asset prices because it can be eliminated through diversification. However, in the realworld, it is difficult for investors to fully diversify their portfolios because of various
reasons such as transaction costs, incomplete information, taxes, and institutional
restrictions including limitations on short sales. Under this circumstance, idiosyncraticrisk would not be fully diversified, thus, some research argues that idiosyncratic risk
would be priced in market (e. g., Merton, 1987; Malkiel and Xu, 2002).
This study considers both systematic risk and idiosyncratic risk, because some
empirical studies suggest that idiosyncratic risk has significant effects on stock returns
or portfolio returns (Goyal and Santa-Clara, 2003; Ang, Hodrick, Xing and Zhang, 2009;
Angelidis, 2010; Fu, 2010). If idiosyncratic risk influences stock returns, investors
would be concerned about it as well as systematic risk. Further, this study also
examines total risk indicating the sum of systematic and idiosyncratic risk andmeasured by the firm’s stock return volatility.

3. Literature Review and Hypotheses Development
3.1. The effect of corporate international diversification on systematic risk
As discussed above, overseas business activities may have conflicting effects on firmrisk, risk-decreasing and risk-increasing. The relation between corporate international
diversification and systematic risk is expected to depend on the net effect of these two
effects. Regarding the relation, previous studies provide inconsistent results.
Some studies find that internationally diversified firms have lower systematic risk.
Agmon and Lessard (1977) find that the foreign sales ratio of American multinationalfirms is related to lower systematic risk estimated based on domestic market. The resultof research conducted by Fatemi (1984) also presents the risk-decreasing effect ofinternational diversification. It shows that a portfolio of multinational firms has lower
systematic risk compared to that of domestic firms. Michel and Shaked (1986) point out
that the average domestic systematic risk of multinational firms is significantly lower
than that of domestic firms. These results imply that multinational operations cancontribute to reduce systematic risk of the firm by exploiting diversification benefits.
On the other hand, some studies indicate that the systematic risk of a firm becomeslarger, as the firm diversifies its operations internationally. Reeb et al. (1998) find that
foreign sales ratio and foreign assets ratio are positively associated with CAPM beta.
They argue that multinational operations increase systematic risk if an increase in the6standard deviation of cash flows resulting from various costs of international
diversification is greater than a decrease in the correlation between the firm anddomestic market by operations in foreign multiple markets. Olibe et al. (2008) alsosuggest positive relations between international diversification proxies and systematicrisk, by including geographical segment data adding to foreign sales and assets. The
increase in systematic risk implies that the effects of the costs of international
diversification exceed the diversification benefits.
As mentioned above, the results of previous studies on the relation between
corporate international diversification and systematic risk are conflicting. As Reeb et al.
(1998) argue, overseas activities can reduce systematic risk, because operations in
multiple foreign markets decrease the correlation between the firm and domestic
market. However, multinational firms is exposed various risks that increase thestandard deviation of their stock returns. It is would be concluded that the relation
between international activities and systematic risk is determined by the net of theseadverse effects. Based on the discussion above, this study examines the relation using
the sample of listed Japanese firms. If the benefits of foreign expansion of Japanesefirms dominate the costs, their systematic risk would decrease as they increaseinternational operations, and vise versa.
So, I formulate the conflicting hypotheses as follows:
H1.a. Corporate international diversification is associated with greater systematic risk.
H1.b. Corporate international diversification is associated with lower systematic risk.
3.2. The effect of corporate international diversification on idiosyncratic risk
Literature on the relation between corporate international diversification and firmrisk mainly focuses on systematic risk. Idiosyncratic risk has been hardly spotlighted,
since it is regarded to be mitigated by diversification. However, some recent studies
argue that idiosyncratic risk may not be fully diversified and form a significant part offirm risk (e.g., Goyal and Santa-Clara, 2003; Ang, Hodrick, Xing and Zhang, 2009;
Angelidis, 2010; Fu, 2010). Some previous literature not only suggests that the risks offoreign expansion contain idiosyncratic factors (e.g., Goldberg and Heflin, 1995; Krapl,
2015), but also provide evidence of the significant relation between international
diversification and idiosyncratic risk, despite its limited number.
Hughes et al. (1975) find that a portfolio of multinational firms has lower
idiosyncratic risk compared to that of domestically oriented firms. They refer that7

investors consider that multinational firms provide substantial diversification benefits.
But, Krapl (2015) suggest that corporate international diversification increases
idiosyncratic risk, and discusses that additional risk factors of international
diversification include idiosyncratic components as well as systematic components. In
terms of the components, it refers that currency risk would be systematic while otherrisks associated with international diversification may mostly be idiosyncratic.
Althoughcorporate international diversification

has significant effects

onidiosyncratic risk, previous studies show conflicting results. Internationally diversified
firms may have lower idiosyncratic risk than domestic firms, because the risk can bedispersed through operations in multiple markets. However, if additional risks ofinternational diversification include idiosyncratic components and they are not
perfectly diversified, idiosyncratic risk may increase, as a firm expands its operations toforeign markets. Some previous studies suggest that risks of foreign expansion include
idiosyncratic factors, although systematic and idiosyncratic natures of the risks havenot been identified definitely. Thus, how corporate international diversificationinfluences idiosyncratic risk depends on which of these two effects is dominant. Whenthe former effect predominates over the latter effect, idiosyncratic risk decreases withinternational diversification, and vise versa.
Therefore, I hypothesize on the relation between corporate international
diversification and idiosyncratic risk as follows:
H2.a. Corporate international diversification is associated with greater idiosyncraticrisk.
H2.b. Corporate international diversification is associated with lower idiosyncratic risk.
3.3. The effect of corporate international diversification on total risk
In this section, I investigate the effects of corporate international diversification on
total risk. The change in systematic risk and idiosyncratic risk causes a change in totalrisk, because total risk indicates the sum of two risks. If foreign expansion has
significant effects on systematic and idiosyncratic risk in the same direction, it also
would influence total risk in the same way. For example, Krapl (2015) finds thatinternational diversification increases systematic risk, idiosyncratic risk, and total risk.
However, the effects on systematic and idiosyncratic risk may be offset against eachother. Goldberg and Heflin (1995) find that firms with greater international
involvement have higher total risk, while they have lower systematic risk. It is due to8

larger portion of idiosyncratic risk which is diversified away. Thus, the relation between
corporate international diversification and total risk would be determined by how
foreign expansion affects systematic and idiosyncratic risk.
So, the hypotheses are established as follows:
H3.a. Corporate international diversification is associated with greater total risk.
H3.b. Corporate international diversification is associated with lower total risk.

4. Data and Methodology
4.1. Sample selection
The sample consists of all firms listed on the Tokyo Stock Exchange (TSE) excluding
financialcompanies.

Financialinformation

andinternational

diversification

information of sample firms are extracted Nikkei NEEDS-FinancialQUEST. Weekly
stock returns data and Kubota & Takehara’s Fama-French data which includes data for
estimating risk proxies are acquired from NPM data service. Since information offoreign assets has been disclosed from 1999, I collect the data from 1999 to 2012.
Observations without positive foreign sales ratio or foreign assets ratio are excluded.

Observations with missing value of variables are also excluded. To minimize theeffects of outliers, I winsorize all of the variables at the 1% level. The final dataset
consists of 1,670 firms and 12,171 firm-year observations of foreign sales ratio, 987
firms and 6,585 firm-year observations of foreign assets ratio.
4.2. Risk measures
This study uses three types of risk parameters, which are systematic risk,
idiosyncratic risk, and total risk. To estimate the risk measures, I employ Fama-French
three-factor model (Fama and French, 1993) composed of the CAPM and two additional
factors.2 The equation of the model is as follows:

The estimated systematic risk in this study may be imperfect, as it just considers thecoefficient of market excess returns ( ) excluding the coefficients of the size effect ( )and the value effect ( ). For that reason, I also estimate the risk measures relying on
the original version of CAPM. The risk measures provide results that are consistent
with the results of this study.
29whereis the stock return of firm i in week t,

is the weekly risk-free rate of

return which is calculated from the rates of 10-year Japanese government bonds,
is the weekly return of value-weighted market portfolio which consists of all listed firms
on the TSE,

is the beta which is the measure of systematic risk,

is the size

premium computed as the average return for the smallest 50% of stocks minus theaverage return for the largest 50% stocks in week t,

is the value premiumcomputed as the average return for the 30% of stocks with the highest book-to-market
ratio minus the average return for the 30% of stocks with the lowest book-to-market
ratio in week t, andtotal risk

is the weekly idiosyncratic stock returns of firm i. I estimate

using the standard deviation of weekly excess stock returns

also estimate idiosyncratic risk
stock returns.Iusing the standard deviation of idiosyncratic, obtained by residuals form the equation. All the risk measures are

based on 1-year (52 weeks) rolling period windows.3
4.3. Corporate international diversification measures
This study uses the ratio of Foreign Sales to Total Sales (FSTS) and the ratio of
Foreign Assets to Total Assets (FATA) as the measure of international diversification.
These two measures are frequently used in previous studies (Reeb et al., 1998; Olibe etal., 2008). Each of these two measures reflects different facets of international
diversification. The ratio of foreign sales to total sales provides a measure of a firm’s
dependence on its foreign markets for sales revenues, while the ratio of foreign assets tototal assets can be regarded as a proxy for a firm’s dependence on foreign production. In
addition, while the ratio of foreign sales cannot fully capture geographical economic
activities of firms, the ratio of foreign assets mitigating the problem of mixed export andforeign subsidiary sales captures geographic structural information.
4.4. Control variables
Based on previous studies, this study includes some control variables in empiricalanalysis to control the other determinants of firm risk. Return on assets (ROA) is

The estimation period is matched to fiscal year end of given observation. For example,
the observation with fiscal year end of March 2012 is estimated with the data from April
2011 to March 2012.
310

expected to be negatively associated with firm risk, because greater profitability canincrease expected stock returns by investors. Firms with greater liquidity may havelower risk, because they are likely to be less sensitive to fluctuations in the economy. In
this study, the Quick ratio defined as the ratio of quick assets to current liabilities isused as the measure of corporate liquidity (LIQ). The quick assets include cash andcurrent assets which can be quickly converted to cash such as account payable andmarketable securities. Dividend payout (DIVPO) defined as the ratio of the firm’s
dividends to net income also is expected to reduce firm risk due to positive perception by
investors. In addition, operating efficiency (EFF) and firm size (SIZE) may contribute to
decrease in risk, because they are related to greater revenue and lower possibility ofbankruptcy, respectively. This study uses the ratio of total revenues to total assets as
the measure of the firm’s operating efficiency and the natural logarithm of total assets
as the proxy for firm size. In contrast, previous studies find that firms with higher
growth opportunities and leverage have greater risk. I define growth opportunity as themarket-to-book ratio (MTB) and firm leverage (LEV) as the ratio of total debt to total
assets.
4.5. Method
To investigate the effect of corporate international diversification on firm risk, thisstudy uses panel data composed of various cross-sectional units. I rely on fixed effects
model to control for unobserved firm-specific characteristics. Estimated regression
model is as follows:

whereis the risk measures of firm i in year t,international diversification,is return on assets,

is the dividend payout ratio,
leverage,is the measures ofis corporate liquidity,

is market-to-book ratio,

is operational efficiency,

is corporate

is firm size measured by the natural

logarithm of total assets. The set of year dummy variables are included to control
time-variant effects, as well as control variables mentioned above.

11

4.6. Descriptive statistics
Panel A of Table 1 presents summary statistics of the sample: number ofobservations, mean, median, and standard deviation of each variables. The average
foreign sales ratio (FSTS) is 0.296 and the average foreign assets ratio (FATA) is 0.228.
Sample firms have average systematic riskof 4.531, and average total riskof 0.846, average idiosyncratic riskof 5.355.

Correlation matrix between the variables is displayed in Panel B of Table 1. The
correlation coefficients among the risk measures are positive. Especially, idiosyncraticrisk

and total risk

show considerably strong correlation of 0.966. The

correlation between foreign sales ratio (FSTS) and foreign assets ratio (FATA) is 0.616.
FSTS is positively correlated with all risk measures and statistically significant at the
1% level, implying that firms with greater foreign sales ratio have lower systematic,
idiosyncratic, and total risk. On the other hand, FATA and systematic risk have apositive correlation which is statistically significant at the 5% level, while thecorrelation coefficients between FATA and other risk measures have no statisticalsignificance. It is possible that the effects of other determinants of firm risk distort therelation between foreign assets ratio and idiosyncratic risk or total risk.

5. Results
5.1. The effect of corporate international diversification on systematic risk
At first, this study investigates the effect of corporate international diversification
on systematic risk. Table 2 shows the results of fixed effect regression. Model 1and 2
represent the results using FSTS as a proxy for corporate international diversification,
while model 3 and 4 represent the results using FATA. For all models, the estimatedbeta is used as the measure of systematic risk. The table shows the results of the basicmodel not including control variables except for year dummies, and the results of theadvanced model with all other control variables.
Both international diversification measures (FSTS and FATA) are positively
associated with systematic risk. In model 1, which is the basic version of regression, theestimated coefficient on FSTS is 0.216 and statistically significant at the 1% level. This
indicates that the level of foreign sales ratio is positively correlated with beta. Even
after controlling for other determinants of systematic risk, the result remains
12unchanged. In model 2, including the complete set of control variables, the estimate
coefficient on FSTS is 0.153 and statistically significant at the 5% level. The coefficienton FSTS of model 2 is lower than that of model 1 and it may result from the effects ofcontrol variables. The results of regression using FATA report are consistent with thoseusing FSTS. In model 3 and 4, the coefficient estimates on FATA are positive (0.32 and0.223) and statistically significant at or less than the 5% level.
Thus, corporate international diversification increases the firm’s systematic risk,even when controlling for other control variables. The regression results of Table 2
represent the positive relation between the international diversification measures andbeta, as supporting the hypothesis 1a that corporate international diversification isassociated with greater systematic risk. It is interpreted that the effects of additionalrisk of foreign expansion predominate over the reduction in the correlation between
multinational firms and domestic market (Reeb et al, 1998; Olibe et al., 2008).
Therefore, firms with more international activities may confront with greatersystematic risk in Japan.
Control variables have significant effects on systematic risk. MTB and LEV are
positively associated with beta, implying that the firms with greater growth
opportunities and leverage have higher systematic risk. However, LIQ, DIVPO, andEFF are negative related with beta. Increase in liquidity, dividend payout, andoperational efficiency contribute to reduction in systematic risk. Opposite to the
expectation, SIZE is positively associated with systematic risk. In Japan, larger firms
have greater systematic risk and this is contrary to the conventional arguments andexisting evidences.
5.2. The effect of corporate international diversification on idiosyncratic riskThis study investigates the effect of corporate international diversification on
idiosyncratic risk, as well as systematic risk, because the risk may be the significant
part of firm risk. Table 3 reports the regression results considering idiosyncratic risk.
The standard variations of idiosyncratic stock returns are used as dependent variables,
instead of betas. Other components of each model are consistent with those of Table 2.
The results in Table 3 show that corporate international diversification is positive
related with idiosyncratic risk based on the regression results. In model 1 and 2, theestimated coefficients on FSTS are positive (0.587 and 0.663) and statisticallysignificant at the 10% level. The estimated coefficients on FATA, in model 3 and 4, arealso positive (1.042 and 1.179) and statistically significant at the 5% level.
13

Corporate international diversification is positively associated with idiosyncratic
risk, after controlling for other determinants of idiosyncratic risk. This result supports
the hypothesis 2a that corporate international diversification is associated with greater
idiosyncratic risk. The result indicates that the risks of foreign expansion include
idiosyncratic factors that become larger with the firm’s increased overseas activities(Krapl, 2015). Unlike the argument of portfolio theory, this finding suggests that
idiosyncratic risk is not fully dispersed by multinational operations, but rather becomes
greater with internationalization.
From the results of the control variables, other determinants also have significant
effects on idiosyncratic risk. Greater growth opportunities and leverage are associatedwith higher idiosyncratic risk. Conversely, liquidity, dividend payout, and operational
efficiency are likely to decrease idiosyncratic risk. Larger firms have lower idiosyncratic
risk, but they have higher systematic risk. Finally, contrary to the expectation,
profitability is positively related to idiosyncratic risk.
5.3. The effect of corporate international diversification on total risk
In this section, I examine how corporate international diversification influences total
risk. Table 4 presents the estimates of the regression models. The standard variations of
weakly stock returns are used as dependent variables. Other components are consistent
with those of Table 2 and 3.
Consistent with the results of regressions regarding systematic and idiosyncraticrisk results, corporate international diversification is positively associated with total
risk. In model 1 and 2, the estimated coefficients on FSTS are positive (0.953 and 0.902)
and statistically significant at the 5% level. Similarly, the estimated coefficients on

FATA, in model 3 and 4, are positive (1.511 and 1.452) and statistically significant at the
1% level. Even when controlling for other determinants of total risk, the positive
relation between corporate international diversification and total risk remains
unchanged. The result also suggest that when firms expand operations internationally,
they become to be exposed to greater costs exceeding benefits, based on the estimates ofsystematic and idiosyncratic risk.

6. Conclusion
This study examines how corporate international diversification affects firm risk.
14Given the portfolio theory, international diversification is considered to contribute to
reducing risk resulting diversification benefits, while multinational firms face
additional costs that increase the firms’ risk. Thus, the relation between corporate
international diversification depends on the net of the adverse effects. The relation isstill unanswered due to the lack of consensus among the results of previous studies.
The regression results using a sample of listed Japanese firms suggest that
corporate international diversification increases systematic risk, idiosyncratic risk, andtotal risk. The international diversification measures, represented by the ratio of
foreign sales and assets, are positively associated with all risk proxies, after controllingother determinants of risk. This result is consistent with previous studies suggestingthat the additional costs of multinational operations such as currency risk, political risk,
and greater agency costs result in greater firm risk s (e.g., Lee and Kwok, 1988; Reeb etal., 1998). Therefore, the result of empirical analysis can be explained that the costs offoreign expansion by Japanese firms may dominate benefits, thereby increasing theircorporate risk.
Given the finding of this study, as firms increase overseas activities, their firm risks
become greater. Even idiosyncratic risk, which is expected to be mitigated bydiversification, also increases with overseas expansion. This result provides
implications for investors that investing in internationally diversified firms leads togreater risk. If investors hold stocks of multinational firms, they will be exposed toincreased idiosyncratic risk as well as systematic risk. In addition, the increase in firmrisk is likely to result in the greater cost of capital, because investors require the higher
returns for the higher risk. It may also influence the firm’s ability to take on capital
investment. Therefore, it is recommended for managers of multinational firms to takean efficient risk management of their foreign operations.

15

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Table 1 Descriptive Statistics
Panel A Summary Statistics

Variables

Observations

Mean

MedianStd Dev

11,797

0.846

0.825

0.406

12,123

4.531

4.108

1.945

12,130

5.355

4.950

2.132

FSTS

12,171

0.296

0.246

0.213

FATA

6,585

0.228

0.199

0.140

ROA

12,472

3.496

2.749

2.994

LIQ

12,472

1.602

1.201

1.331

DIVPO

12,472

0.461

0.257

0.773

MTB

12,472

1.144

1.003

0.593

LEV

12,472

0.492

0.498

0.203

EFF

12,472

1.010

0.912

0.478

SIZE

12,472

11.18610.9901.567=systematic risk;=idiosyncratic risk;=total risk；FSTS = foreign sales/total sales; FATA

=foreign assets/total assets;; ROA=return on assets; LIQ=quick ratio; DIVPO=dividend payout ratio;
MTB=market-to-book ratio; LEV= total debts/total asset; EFF=total revenue/total assets; SIZE=thenatural logarithm of total assets

18

Table 1 Descriptive Statistics
Panel B Correlation Matrix

1

2

3

4

5

6

7

8

9

10

11

12

1．β

1

2．

0.330**

1

3．

0.497**

0.966**

1

3. FSTS0.138**

0.043**

0.076**

1

4. FATA

0.023*-0.013-0.0001

0.616**

1

5. ROA-0.0120.037**

0.022*

0.191**

0.144**

1

6. LIQ-0.123**-0.061** -0.082**

0.054**

0.004

0.223**

7. DIVPO-0.052**-0.036** -0.023**-0.055*-0.047** -0.327**

0.045**

1

8. MTB

0.100**

0.186**

0.181**

0.145**

0.118**

0.110**-0.135**

9. LEV

0.221**

0.162**

0.193**-0.066** -0.051** -0.349**-0.700** -0.059**-0.090** 1

10. EFF

0.002-0.0030.005-0.036** 0.071**

0.026**-0.282** -0.070**-0.040** 0.307**

1

11. SIZE

0.089**-0.240** -0.180**0.204**-0.083**-0.181** -0.036**

0.094**-0.026** 1

0.258**

0.551**** p < 0.001; * p< 0.05

19

1

0.223**

Table 2 The effect of corporate international diversification on systematic riskβIntercept

FSTS

Model 1Model 2Model 3Model 40.820***-0.0540.881***-0.317(31.71)(-0.17)(29.56)(-0.75)0.216***

0.153**(3.05)(2.16)
0.320***

0.223**(3.09)(2.06)

FATA

ROA

LIQ

DIVPO

MTB

LEV

EFF

SIZE

0.0004-0.004(0.17)(-1.49)-0.011-0.021*(-1.41)(-1.95)-0.008*-0.0005(-1.78)(-0.07)0.078***

0.085***(5.46)(5.31)

0.156*

0.057(1.89)(0.50)-0.058*-0.006(-1.83)(-0.13)0.082***

0.102***(2.95)(2.77)

Year Dummies

YES

YES

YES

YES

N

11,797

11,797

6,411

6,411

R-sq

0.040

0.053

0.048

0.059

*** p < 0.01; ** p < 0.05; * p< 0.10

20

Table 3 The effect of corporate international diversification on idiosyncratic risk

Intercept

FSTS

Model 1Model 2Model 3Model 4

3.408***

10.61***

5.488***

11.36***(26.49)(7.10)(37.19)(5.75)

0.587*

0.663*(1.65)(1.94)
1.042**

1.179**(2.07)(2.49)

FATA

ROA

LIQ

DIVPO

MTB

LEV

EFF

SIZE

0.030***

0.028**(2.81)(2.12)-0.051-0.025(-1.46)(-0.53)-0.055**-0.009(-2.46)(-0.30)0.730***

0.573***(11.46)(7.98)

2.334***

2.276***(6.66)(4.71)-0.612***-0.546***(-4.29)(-3.33)-0.534***-0.589***(-4.01)(-3.43)

Year Dummies

YES

YES

YES

YES

N

12,12312,123

6,572

6,572

R-sq

0.293

0.336

0.328

0.356

*** p < 0.01; ** p < 0.05; * p< 0.10

21

Table 4 The effect of corporate international diversification on total risk

Intercept

FSTS

Model 1Model 2Model 3Model 44.170***

9.890***

6.917***

10.70***(30.08)(6.08)(42.80)(4.99)

0.953**

0.902**(2.48)(2.45)
1.511***

1.452***(2.74)(2.73)

FATA

ROA

LIQ

DIVPO

MTB

LEV

EFF

SIZE

0.025**

0.017(2.20)(1.17)-0.086**-0.095(-2.08)(-1.42)-0.055**0.001(-2.25)(0.04)

0.816***

0.698***(12.25)(8.50)

2.235***

2.013***(5.76)(3.75)-0.508***-0.349*(-3.27)(-1.91)-0.346**-0.411**(-2.39)(-2.22)

Year Dummies

YES

YES

YES

YES

N

12,13012,130

6,577

6,577

R-sq

0.308

0.352

0.359

0.387

*** p < 0.01; ** p < 0.05; * p< 0.10

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