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International Finance Discussion Papers
The International Finance Discussion Papers logo links to the International Finance Discussion Papers home page Portfolio Diversification and the Cross-Sectional Distribution of Foreign Investment
Alexandra Tabova
2013-1091  (November 2013)

Abstract:  In this paper I explore the role of portfolio diversification in explaining the distribution of foreign investment across countries. I capture the portfolio diversification motive by a measure of country-specific riskiness, “covariance risk”, which I construct as how countries' growth rates covary with the stochastic discount factor of a representative international investor. My key new empirical finding is a strong and significant correlation between this new measure of country riskiness and foreign investment allocations. Less risky countries, i.e. countries whose growth rates are more highly correlated with the investor's stochastic discount factor, receive larger investment shares than more risky countries. I interpret this result as evidence that investors do take into account diversification opportunities, not only for portfolio investment decisions, but also for foreign direct investment decisions. My empirical results confirm the theoretical predictions of standard portfolio allocation models.

Full paper (174 KB PDF)

Keywords
Foreign direct investment, global risk, international portfolio choice, portfolio diversification

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Last update: November 21, 2013