7 CHAPTER INTERNATIONAL INVESTMENT AND CAPITAL FLOWS
CHAPTER OUTLINE
Portfolio Diversification Home Bias in International Investment International Investment Opportunities The Globalization of Equity Markets Direct Foreign Investment Capital Flight Capital Inflow Issues Summary Exercises References
LECTURE HINTS
1. In recent years, the Wall Street Journal has published a supplement on "Global Finance" every September. This supplement is a rich source of anecdotes and data related to international investment. The Wall Street Journal index is available at libraries to aid in finding the issue which includes the supplement. In addition, Euromoney.com, offers many interesting articles an international investment. For detailed information on foreign firms traded on U.S. stock exchanges, see www.adr.com.
2.
SUGGESTED ANSWERS TO CHAPTER 7 EXERCISES
Exercise 1
Portfolio diversification and net after-tax return considerations are the main reasons for two-way capital flows. To have a diversified portfolio we can hold an asset even with a lower expected return. Also, different rates of taxation on capital gains and interest incomes can make the positive interest differential between countries reduced, or negative. Basically, with constant interest rates, as wealth grows, two-way capital flows occur if investors want to maintain the same portfolio shares devoted to different countries' assets.
Exercise 2
Modern portfolio theory suggests that by investing in assets with returns that are not perfectly correlated over time, a given return can be obtained at a lower risk. Suppose we have two different portfolios, A and B. Portfolio A has only domestic securities while B has both domestic and foreign securities. Because we expect the domestic and foreign countries to have different economic conditions, returns on foreign are securities more likely to be less related to returns on domestic securities than would additional domestic securities. Thus, a portfolio including both domestic and foreign securities can have a smaller risk (variance) than a portfolio having only domestic securities.
Exercise 3
We expect a multinational firm to be affected significantly by foreign factors. If a multinational firm's stock price is affected only by domestic factors rather than foreign factors, then we expect the stock of a domestic multinational firm to have equal risk characteristics as the stock of a firm with purely domestic operations.
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Exercise 4
Political risk and lack of information would be the main reasons to prefer to invest in domestic assets than foreign assets, aside from net after-tax return considerations.
Exercise 5
Financial portfolio investments are purely financial assets, such as bonds, stocks, and foreign currency while direct foreign investments are physical investments in foreign operating units. The motives of risk and return (i.e., lowest risk, or maximum return) are shared by both financi...