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Discussion Paper Details

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

Author(s): Itay Goldstein and Assaf Razin

Publication Date: February 2003

Keyword(s):

Programme Area(s): International Macroeconomics

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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Bibliographic Reference

Goldstein, I and Razin, A. 2003. 'An Information-Based Trade-off Between Foreign Direct Investment and Foreign Portfolio Investment: Volatility, Transparency and Welfare'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=3747