Portfolio Diversification and the Cross-Sectional Distribution of Foreign Investment

36 Pages Posted: 8 Dec 2013

See all articles by Alexandra Tabova

Alexandra Tabova

Board of Governors of the Federal Reserve System

Date Written: November 5, 2013

Abstract

In this paper I explore the role of portfolio diversification in explaining the distribution of foreign investment across countries. I capture the portfolio diversification motive by a measure of country-specific riskiness, “covariance risk,” which I construct as how countries' growth rates covary with the stochastic discount factor of a representative international investor. My key new empirical finding is a strong and significant correlation between this new measure of country riskiness and foreign investment allocations. Less risky countries, i.e. countries whose growth rates are more highly correlated with the investor's stochastic discount factor, receive larger investment shares than more risky countries. I interpret this result as evidence that investors do take into account diversification opportunities, not only for portfolio investment decisions, but also for foreign direct investment decisions. My empirical results confirm the theoretical predictions of standard portfolio allocation models.

Keywords: Foreign direct investment, global risk, international portfolio choice, portfolio diversification

JEL Classification: F21, F34, F41, G11

Suggested Citation

Tabova, Alexandra, Portfolio Diversification and the Cross-Sectional Distribution of Foreign Investment (November 5, 2013). FRB International Finance Discussion Paper No. 1091. Available at SSRN: https://ssrn.com/abstract=2364598 or http://dx.doi.org/10.2139/ssrn.2364598

Alexandra Tabova (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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