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Understanding Global CrisesAn Emerging Paradigm$
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Assaf Razin

Print publication date: 2015

Print ISBN-13: 9780262028592

Published to MIT Press Scholarship Online: May 2016

DOI: 10.7551/mitpress/9780262028592.001.0001

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Foreign Investment: Liquidity Shocks

Foreign Investment: Liquidity Shocks

(p.127) 10 Foreign Investment: Liquidity Shocks
Understanding Global Crises

Assaf Razin

The MIT Press

The key mechanisms through which information frictions affect the composition and the volatility of international capital flows are market based. Foreign direct investors get more efficient outcomes than foreign portfolio investors because the former have more direct control over management. Thus, they are able to make a better-informed decision of how to run the business. However, the better information mires FDI investors with the “lemons” problem: If the investors’ liquidity dries up, forcing the investors to sell off foreign subsidiaries, market participants would not know whether the subsidiary is liquidated because of the investors’ liquidity problems or because of bad inside information about the profitability of the subsidiary. Consequently, the market will place a discount on assets sold by an FDI investor, who has the inside information, unlike the FPI investor. Thus, the liquidated stock of an FDI investor is sold at a discount. High-liquidity-risk investors opt for FPI investment, whereas low-liquidity-risk investors opt for FDI investment.

Keywords:   Lemon problem in international finance, Efficiency-liquidity tradeoffs, Foreign direct investment vs. foreign portfolio investment

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