Equity Price and Equity Flows:
Testing Theory of the Information-Efficiency Tradeoff
Assaf Razin
Anuk Serechetapongse
Cornell University
June 14th, 2011
1
Capital market liberalization gave rise to large amount of
international equity investments, which are
I.
Foreign Direct Investments (FDI)
II. Foreign Equity Investments (FPI)
2
How do different types of international equity investments
interact amid the risk of liquidity crisis?
Goldstein and Razin (2006):
 When FDI is sold, the market does not know whether it is sold
because of liquidity shock or because of low productivity.
 Hence, the price direct investment must incur informational
discount if sold before maturity. As a result, investors would tilt
their investments towards FPI if they expect greater liquidity
needs.
3
How do different types of international equity investments
interact amid the risk of liquidity crisis?
Kirabaeva (2009):
 On one hand, as a fraction of direct investors increases, the
price of direct investment goes down
 On the other hand, as we have more direct investors with higher
liquidity risk, it is more likely that a direct investment is sold due
to liquidity needs. This improves the price of the prematurely
sold direct investment.
4
Three testable hypotheses:
I.
Price Discount Hypothesis – the FDI-to-FPI price differential
is negatively related to the risk of liquidity crisis
II. Equity Composition Hypothesis – the FDI-to-FPI composition
of foreign equity investment skews towards FPI when investors
are expected to experience liquidity shortage in the future
III. Strategic Complementarity Hypothesis – the FDI-to-FPI
composition of foreign equity investment will skew towards
FDI if the initial proportion of FDI-to-FPI is large
5
Measure of FDI-to-FPI Ratio
 The data of FDI-to-FPI ratio is from Lane and Milesi-Ferretti (2007)
 The sample period is from 1970 – 2004
 They distinguish four types of international assets and liabilities:
foreign direct investment, foreign portfolio(equity) investment,
official reserves, and external debt
 The outward FDI and FPI from the source countries are measured
using the data of the stock of FDI and equity assets.
 The inward FDI and FPI into the host countries are measured using
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the data of the stock of FDI and equity liabilities.
Proxy of Liquidity Crisis:
 As in Goldstein, Razin, and Tong (2007), the proxy of a liquidity
crisis is the incident when a purchase of external assets is negative
(or a sales of external assets is positive)
 When a country faces liquidity crisis, many types of assets, such
as reserves, direct investments, equity investments, and other assets,
will be sold
7
Measures of a Liquidity Crisis
I. Liquidity Crisis Severity
If the purchase of external assets is negative,
Liquidity Crisis Severity = sales of external assets
total assets
If the purchase of external assets is positive,
Liquidity Crisis Severity = 0
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Measures of a Liquidity Crisis
I. Liquidity Crisis Dummy
II. Liquidity Crisis Dummy
• Liquidity
Crisis
Dummy
Liquidity
Crisis
Dummy
= =
1 ; if the purchase of external assets
is negative
0 ; otherwise
These measures are estimated using the data on annual flows
in external assets from the IMF’s Balance of Payments dataset.
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Empirical Methodology
The liquidity crisis severity and dummy variables will be
instrumented on the following excluded instruments:
1.Current account balance to GDP
2. Government budget balance to GDP
3. The ICRG political risk measure
4. The ICRG financial risk measure
Then the instrumented liquidity crisis variable will be used as an
explanatory variable of interest in the structural equations that will
test the three hypotheses.
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Testing the Price Discount Hypothesis
ln(PFDI/PFPI)i,t = ηWi,t + ζ0(Instrumented Liquidity Crisisi,t+1)
+ yeart + ui + i,t
where
ln(PFDI/PFPI)i,t = the log of FDI price to FPI price
Instrumented Liquidity Crisisi,t+1 = the liquidity crisis dummy or the
liquidity crisis severity in the
next period (instrumented)
Wi,t = controls
(log of GDP, log of GDP per capita, inflation)
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Testing the Price Discount Hypothesis
PFPIi,t will be proxied by the stock market index
PFDIi,t will be proxied as follow,
PFDIi,t = ωPmarketi,t + (1-ω)Pearningsi,t
where
ω is the share of the market component of FDI over the total FDI inflows
Pmarketi,t will be proxied by the stock market index
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Testing the Price Discount Hypothesis
Pearningsi,t will be estimated using the method in del Rio (2004)
Pearningsi,t = pi*[(ci*cgdp)/(ki*rgdpl)]
where
pi = the PPP price level of investment
cgdp = GDP per capita at world price
ci = the investment share of cgdp
rgdpl = GDP per capita at constant world price
ki = the investment share of rgdpl
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The Effect of Liquidity Crisis on the FDI to FPI Price Ratio (Fixed Effects)
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Testing the Equity Composition Hypothesis
ln(FPI/FDI)i,t = Xi,t + 0(Instrumented Liquidity Crisisi,t+1)
+ yeart + ui + i,t
where
ln(PFDI/PFPI)i,t = the log of FDI price to FPI price
Instrumented Liquidity Crisisi,t+1 = the liquidity crisis dummy or the
liquidity crisis severity in the
next period (instrumented)
Xi,t = controls
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Testing the Equity Composition Hypothesis
Controls:
From Goldstein, Razin, and Tong (2007)
1. log of GDP
2. log of GDP per capita at a constant price
3. log of stock market capitalization
4. natural log of trade openness (export plus import to GDP)
5. lag of real exchange rate
From Chinn and Ito (2005)
6. GDP deflator
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The Effect of Liquidity Crisis on the Outward FPI to FDI Ratio
17
The Effect of Liquidity Crisis on the Outward FDI (Level)
18
The Effect of Liquidity Crisis on the Outward FPI (Level)
19
Testing the Strategic Complementarity Hypothesis
ln(FPI/FDI) i,t = Xi,t + 0(Instrumented Liquidity Crisisi,t+1)
+1(Instrumented (FDI/All Inward Capital)i,t-1*( Liquidity Crisisi,t+1) )
+yeart + ui + i,t
where
ln(FPI/FDI)i,t = the log of FPI outflows to FDI inflows
Liquidity Crisisi,t+1 = the liquidity crisis dummy or the liquidity
crisis severity in the next period
(FDI/All Inward Capital)i,t-1 = the initial fraction of direct investment
Xi,t = controls
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The Effect of Liquidity Crisis and the Initial Direct Investment Portion
on the Outward FPI to FDI Ratio (Fixed Effects)
21
The Effect of Liquidity Crisis and the Initial Direct Investment Portion
on the Outward FPI to FDI Ratio (Dynamic Panel)
22
Robustness Tests:
1. Run the regression on the level of M&As
2. Add one additional variable, capital account openness index
 Main results don’t change
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Conclusion

The empirical results give strong support for the three
hypotheses

Greater expected liquidity problems increase the price
discount, have a significant negative effect on the gross
outward FDI, and positive effect on the ratio between FPI
and FDI
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