Working Paper

Portfolio diversification and the cross-sectional distribution of foreign investment

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.

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: International Finance Discussion Papers

Publication Date: 2013

Number: 1091