Foreign Direct Investment as a Determinant of Cross-Country Stock~Market Comovement

We develop a theoretical framework in order to investigate the link between two recent trends: (i) the rise in cross-country stock market correlations over the past three decades, and (ii) the increase in global foreign direct investment (FDI) positions over the same period. Our objective is twofold: first, we investigate empirically the channel through which the rise in global stock market correlations is associated with the observed increase in global FDI. Second, we develop a two-country stochastic asset pricing model with multinational firms that allows us to quantify the extent to which the recent rise in global FDI can account for the observed increase in cross-country stock market comovement. Calibrating three versions of the model (finnancial autarky, incomplete markets and complete markets) to the US and the rest-of-the-world, we find that a permanent inrcease in FDI positions, as observed from mid 1990s to mid 2000s, leads to substantial increase in cross-country stock market comovements. Increases in FDI alone can account for approximately one third of the observed increase in stock market correlations. We also discuss the role of portfolio diversification and, more generally, asset market integration.