Volatility of FDI and Portfolio Investments : The Role of Information, Liquidation Shocks and Transparency

The paper develops a model of foreign direct investments (FDI) and foreign portfolio investments. FDI is characterized by hand-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 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. We show that this pattern may become weaker as the transparency in the capital market or the corporate governance in the host economy increase