An Information-Based Trade Off between Foreign Direct Investment and Foreign Portfolio Investment: Volatility, Transparency, and Welfare

47 Pages Posted: 3 Jan 2003 Last revised: 14 May 2014

See all articles by Itay Goldstein

Itay Goldstein

University of Pennsylvania - The Wharton School - Finance Department

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)

Multiple version iconThere are 2 versions of this paper

Date Written: January 2003

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.

Suggested Citation

Goldstein, Itay and Razin, Assaf, An Information-Based Trade Off between Foreign Direct Investment and Foreign Portfolio Investment: Volatility, Transparency, and Welfare (January 2003). NBER Working Paper No. w9426. Available at SSRN: https://ssrn.com/abstract=366463

Itay Goldstein

University of Pennsylvania - The Wharton School - Finance Department ( email )

The Wharton School
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Assaf Razin (Contact Author)

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

P.O. Box 39040
Ramat Aviv, Tel Aviv, 69978
Israel
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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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Germany

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

Centre for Economic Policy Research (CEPR)

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United Kingdom

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