Multinationals as Arbitrageurs: The Effect of Stock Market Valuations on Foreign Direct Investment

Abstract

Empirical evidence of imperfect integration across world capital markets suggests a role for cross-border arbitrage by multinationals. Consistent with multinational arbitrage as a determinant of foreign direct investment (FDI) patterns, we find that FDI flows increase sharply with source-country stock market valuations-particularly the component of valuations that is predicted to revert the next year, and particularly in the presence of capital account restrictions that limit other mechanisms of cross-country arbitrage. The results suggest the existence of a cheap financial capital channel in which FDI flows reflect, in part, the use of relatively low- cost capital available to overvalued parents in the source country.

Keywords: Corporate investment, inefficient markets, behavioral finance, foreign direct investment, international finance

JEL Classification: G31