Working Paper: CEPR ID: DP3033
Authors: Magnus Dahlquist; Gran Robertsson
Abstract: We study the investment behaviour of foreign investors in association with an equity market liberalization, and find a strong link between foreigners' trading and local market returns. In the period following the liberalization, foreigners' net purchases led to a permanent increase in prices, or equivalently, a permanent reduction of the cost of equity capital. We also find a strong link between a firm's fraction of foreign ownership and the magnitude of the reduction of cost of capital. Foreign investors seem to prefer large and well-known firms, and these firms realize the most sizeable cuts in capital costs. Furthermore, our analysis suggests that foreigners act like non-informed feedback traders. In particular, they increase their net holding in firms that have recently performed well. Analysing foreigners' performance, we find very little evidence of informed trading, suggesting that risk sharing is the most plausible explanation for the reduction in the cost of equity capital.
Keywords: Feedback Trading; Momentum; Portfolio Flows
JEL Codes: G11; G12; G14; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Foreigners' net purchases (F21) | Significant increases in prices (P22) |
| Significant increases in prices (P22) | Permanent reduction in the cost of equity capital (G32) |
| Foreign ownership fraction (F23) | Magnitude of price impacts (E30) |
| Foreigners' trading activities (F10) | Risk-sharing benefits (D16) |
| Foreign investors' behavior (F21) | Increase in net holdings in firms that performed well (G32) |
| Foreigners' trading activities (F10) | Informational advantages (D83) |