Theory of foreign portfolio investment

This dissertation examines one category of international capital flows, private portfolio investments (private refers to the source of capital). There is an overall lack of a coherent and consistent definition of foreign portfolio investment. We clarify these definitional issues.^ Two main questions that pertain to private foreign portfolio investments (FPI) are explored. The first problem is the phenomenon of home preference, often referred to as home bias. Related to this are the observed cross-investment flows between countries that seem to contradict the textbook rendition of private FPI. A description of the theories purporting to resolve the home preference puzzle (and the cross-investment one) are summarized and evaluated. Most of this literature considers investors from major developed countries. I consider--as well--whether investors in less developed countries have home preference.^ The dissertation shows that home preference is indeed pervasive and profound across countries, in both developed and emerging markets. For the U.S., I examine home bias in both equity and bond holdings as well. I find that home bias is greater when we look at equity and bond holdings than equity holdings solely.^ In this dissertation a model is developed to explain home bias. This model is original and fills a gap in the literature as there have been no satisfactory models that handle at the same time both home preference and cross-border holdings in the context of information asymmetries. This model reflects what we see in the data and permits us to reach certain results by the use of comparative statics methods. The model suggests, counter-intuitively, that as the rate of return in a country relative to the world rate of return increases, home preference decreases. In the context of our relatively simple model we ascribe this result to the higher variance of the now higher return for home assets. We also find, this time as intended, that as risk aversion increases, investors diversify further so that home preference decreases.^ The second question that the dissertation deals with is the volatility of private foreign portfolio investment. Countries that are recipients of these flows have been wary of such flows because of their perceived volatility. Often the contrast is made with the perceived absence of volatility in foreign direct investment flows. I analyze the validity of these concerns using first net flow data and then gross flow data. The results show that FPI is not, in relative terms, more volatile than other flows in our sample of eight countries (half were developed countries and the rest were emerging markets).^ The implication therefore is that restricting FPI flows may be harmful in the sense that private capital may not be allocated efficiently worldwide to the detriment of capital poor economies. More to the point, any such restrictions would in fact be misguided. ^