Working Paper: NBER ID: w10559
Authors: Malcolm Baker; C. Fritz Foley; Jeffrey Wurgler
Abstract: Foreign direct investment offers a rich laboratory in which to study the broader economic effects of securities market mispricing. We outline and test two mispricing-based theories of FDI. The cheap assets' or fire-sale theory views FDI inflows as the purchase of undervalued host country assets, while the cheap capital' theory views FDI outflows as a natural use of the relatively lowcost capital available to overvalued firms in the source country. The empirical results support the cheap capital view: FDI flows are unrelated to host country stock market valuations, as measured by the aggregate market-to-book-value ratio, but are strongly positively related to source country valuations and negatively related to future source country stock returns. The latter effects are most pronounced in the presence of capital account restrictions, suggesting that such restrictions limit cross-country arbitrage and thereby increase the potential for mispricing-driven FDI.
Keywords: Foreign Direct Investment; Stock Market Mispricing; Cheap Capital; Investment Patterns
JEL Codes: G31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Capital account restrictions (F32) | Effect of mispricing on FDI (F23) |
| Stock market mispricing (G19) | FDI outflows (F21) |
| Overvalued source countries (F29) | FDI outflows (F21) |
| High market-to-book value ratio (G32) | FDI outflows (F21) |
| Mispricing in source country (F31) | FDI patterns (F23) |
| Undervalued host country assets (F21) | FDI inflows (F21) |