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An Information-Based Trade-off Between Foreign Direct Investment and Foreign Portfolio Investment: Volatility, Transparency and Welfare

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Goldstein, Itay
Razin, Assaf

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Abstract

The Paper develops a model of foreign direct investments (FDI) and foreign portfolio investments. FDI is characterized by hands-on management style that enables the owner to obtain relatively refined information about the productivity of the firm. This superiority, relative to portfolio investments, comes with a cost: a firm owned by the relatively well-informed FDI investor has a low resale price because of ‘lemons’ type asymmetric information between the owner and potential buyers. Consequently, investors who have a higher (lower) probability of getting a liquidity shock that forces them to sell early will invest in portfolio (direct) investments. This result can explain the greater volatility of portfolio investments relative to direct investments. Motivated by empirical evidence, we show that this pattern may be weaker in developed economies that have higher levels of transparency in the capital market and better corporate governance. We also study welfare implications of the model.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3747.

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Date of creation: Feb 2003
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Handle: RePEc:cpr:ceprdp:3747

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F00 - International Economics - - General - - - General
F20 - International Economics - - International Factor Movements and International Business - - - General
F30 - International Economics - - International Finance - - - General

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References listed on IDEAS
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Yamin Ahmad & Pietro Cova & Rodrigo Harrison, 2004. "Foreign Direct Investment versus Portfolio Investment : A Global Games Approach," Working Papers 05-03, UW-Whitewater, Department of Economics. [Downloadable!]
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