Equity Prices and Equity Flows: Testing Theory of the Information-Efficiency Tradeoff

36 Pages Posted: 1 Jan 2011

See all articles by Assaf Razin

Assaf Razin

Tel Aviv University - Eitan Berglas School of Economics; National Bureau of Economic Research (NBER); CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR)

a s

affiliation not provided to SSRN

Multiple version iconThere are 2 versions of this paper

Date Written: December 2010

Abstract

The paper tests three hypotheses concerning foreign equity investment in the presence of liquidity risk. First, the FDI-to-FPI price differential is negatively related to liquidity risk (the "Price Discount Hypothesis"). The idea is that market participants do not know whether the FDI investor liquidates a firm because of an idiosyncratic liquidity shock, or because, as an informed investor, the firm is hit by a productivity shock. Second, the FDI-to-FPI composition of foreign equity investment skews towards FPI, if investors are expected to experience liquidity shortage in the future (the "Equity-Composition Hypothesis"). The idea is that because direct investments are more costly to liquidate, due to the price discount, the more severe is the expected liquidity shock, the smaller is the FDI-to-FPI ratio. Third, the FDI-to-FPI composition of foreign equity flows skews towards FDI, the larger are past FDI-to-FPI stocks (the "Strategic Complementarity Hypothesis"). The idea is that high liquidity need investors generate a positive information-externality for low liquidity need investors among investors who choose FDI, and further increases in the number of FDI investors comes from mainly high liquidity need investors. Such an increase reinforces the information externality, thereby lowering the FDI-to-FPI price discount, creating further incentives for investors to choose FDI. The paper brings these hypotheses to country level data consisting of a large set of developed and developing countries over the period 1970 to 2004. The evidence gives strong support to the hypotheses. To test the hypothesis, we apply also a dynamic panel model to examine the variation of FPI relative to FDI for source and host countries from 1985 to 2004. Country-wide sales of external assets are used as a proxy for liquidity problems. We estimate the determinants of liquidity problems, and then test the effect of expected liquidity problems on stock prices, the ratio of FPI to FDI and gross flows of FDI and FPI. We find strong support for the hypotheses: greater expected liquidity problems increase the price discount, have a significant positive effect on gross flows of FPI, negative effect on gross flows of FPI, and positive effect on the ratio between FPI and FDI.

Suggested Citation

Razin, Assaf and s, a, Equity Prices and Equity Flows: Testing Theory of the Information-Efficiency Tradeoff (December 2010). NBER Working Paper No. w16651. Available at SSRN: https://ssrn.com/abstract=1732881

Assaf Razin (Contact Author)

Tel Aviv University - Eitan Berglas School of Economics ( email )

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Israel
+972 3 640 7303 (Phone)
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National Bureau of Economic Research (NBER) ( email )

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CESifo (Center for Economic Studies and Ifo Institute)

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Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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