Foreign Portfolio Investment and Informativeness of Foreign Direct Investment

Abstract

This paper studies how investors allocate their portfolio equity investment internationally. I develop a model to formalize the mechanism by which investors extract the information about foreign target countries from foreign direct investment (FDI): When investors make FDI, due to their control and monitoring as insiders, they obtain the information about the returns of overseas subsidiaries and thereby extract the information about the returns of portfolio investment. I refer to the extent to which FDI predicts the returns of foreign portfolio investment (FPI) as the informativeness of FDI. My model suggests that FPI is more sensitive to FDI if FDI has a higher degree of informativeness, i.e., if FDI provides more information that helps investors predict the returns of FPI in the target country. Guided by the theoretical model, I construct measures for the informativeness of FDI and find that it has a strong positive effect on the correlation between FPI and FDI, which provides empirical evidence for the model's prediction. Moreover, this effect is robust to various control variables and to different estimation specifications.