Question

3. Discuss international capital movements. In particular:

1. State the difference between portfolio investments and direct investments.
2. List the main determinants of both types of capital movements.
3. Argue about the role of risk diversification in explaining “two-way” capital flows.

Answer 1

a)

A direct investment, commonly referred to as foreign direct investment is an investment in the form of a controlling ownership in a business in one country by an entity based on another country Portfolio investment is the the ownership of a stock Bond or any other financial asset with the expectation that it will earn a return or grow in value over time or both.

Foreign Portfolio investment and direct investment can be distinguished as follows

* Nature Of AssetsI which investment is made

foreign direct investment is made in productive assets and foreign portfolio investment is made in in financial assets like stocks ,bonds, Mutual Funds etc

* Rights given by the investment

Direct investment gives investors ownership right as well as management right p.investment gives investors only ownership right not a management right.

*Power of decision making

lnvestors who make direct investment can engage in decision making of a firm. on the other hand the investors who make portfolio investment can't be involved in decision making.

* Difference in approach

The investors who want to make direct investment enter country with a long-term approach they cannot depart from the country easily .Investors who are interested in portfolio investment can plan for long but often they have short term plan and they can easily depart from the country.

b) Following are the main determinants of foreign Direct investment.

*Market size and growth potential

Largest host countries' market may be associated with the highest foreign direct investment due to large potential demand and low costsdue to economies of scale

*Openness

Investing firms must benefit from circumventing trade barriers through building protection sites abroad.

*Political stability

Surveys of investors have indicated that political and macro economic stability is one of the key concerns of foreign investors.

*A weaker real exchange rate might be expected to increase vertical FDI ,as investing firms take advantage of relatively lower prices in the market.

Now let's look at the main factors influencing FPI

*Ownership specific advantages

It is self evident that for foreign portfolio investment to occur,the investing rntoty must have capital to invest this may be regarded as an advantage over other entities that do not possess that or do not possess as much of it.

* Location specific advantage

Location specific advantage of foreign portfolio investment reflect the likely opportunities of securing good rate of return on capital invested. Where the expected rate of return, discounted for risk is higher in the home country than else ware, domestic investment will be preferred to foreign investment. where the reverse in the case ,choice between different foreign location can be assessed by the same criteria as those used to evaluate the choice of location for FDI, with us all exception that and in the case of one looks at location advantages from the angle how they affect the prosperity of the recipient entity rather than that of the investing company.

* externalization advantages

There is no reason why finance capital should not be treated like that of any other intangible asset or part of a group of indelible assets the divisibility of foreign portfolio investment together with its homogeniety make the market involve fever transactions or coordination cost than real intangible assets .For this reason, the volume of foreign portfolio investment can exceed the value of cross border in there firm flows of intangible assets.

3) portfolio theory tells us that by investing in securities with yields that are inversely related overtime, a given yield can be obtained at a smaller or a higher yield can be obtained for the same level of risk for the portfolio as a whole. Since yeilds on foreign securities are more likely to be inversely related to the on domestic securities, a Portfolio including both domestic and foreign securities can have higher average yield and or lower risk than a Portfolio containing only domestic securities.

To achieve such a balanced portolio, a two-way capital flow may be required. For example, if stock A (with the same average yield but lower than that of stock B )is available in one country, while stock B( with yeilds inversely related to the yields on stock A) is available in another country . Investors in the first Nation must also purchase stock B ( ie invest in the second nation) , and Investors in the second nation must also purchase stock A(ie invest in the first nation) to achieve a balanced portfolio.Risk diversifcation can thus explain two-way international capital flows.