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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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  • Itay Goldstein
  • Assaf Razin

Abstract

The paper develops a model of foreign direct investments (FDI) and foreign portfolio investments. FDI is characterized by hands-on management style which 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 a 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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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9426.

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Date of creation: Jan 2003
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Publication status: published as Goldstein, Itay and Assaf Razin. "An information-based trade off between foreign direct investment and foreign portfolio investment." Journal of International Economics 7, 1 (September 2006): 271-295.
Handle: RePEc:nbr:nberwo:9426

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Cited by:
  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.

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