Essays On International Investment Allocation: The Role Of Liquidity, Asymmetric Information And Beliefs

My dissertation addresses topics of international finance. The first chapter develops a theoretical framework to analyze the composition of foreign investment during liquidity crises. The second chapter examines the role of adverse selection and liquidity in the breakdown if trade during crisis. The third chapter studies the equity home bais puzzle in a decision-theoretic framework.In the first chapter, I develop a two-country model that analyzes the compo-sition of capital flows (direct vs. portfolio) across two countries in the presenceof heterogeneity in liquidity risk and asymmetric information about investmentproductivity. Direct investment is characterized by higher profitability and privateinformation about investment productivity, while portfolio investment providesgreater risk diversification. I demonstrate the possibility of multiple equilibria dueto strategic complementarities in choosing direct investment. I analyze the effect ofan increase in the liquidity risk on the composition of foreign investment. If thereis a unique equilibrium, then higher liquidity risk leads to a higher level of foreigndirect investment (FDI). If, however, there are multiple equilibria, higher liquidityrisk may lead to the opposite effect, a decline of FDI. In this case, an out.ow ofFDI is induced by self-ful.lling expectations. The dual effect of increased liquid-ity risk on capital flows can be related to empirically observed patterns of foreigninvestment during liquidity crises. Furthermore, my model offers a liquidity-basedexplanation for the phenomenon of bilateral FDI flows among developed countries,and one-way FDI flows from developed to developing countries.In the second chapter, I present a model that illustrates how adverse selection in financial markets can lead to increased asset price volatility and possibly to a breakdown of trade. The asymmetric information about asset returns generates the Akerlof's lemons problem, where buyers do not know whether the asset is sold because of its low quality or because the seller has experienced a sudden need for liquidity. The adverse selection can lead to equilibrium with no trade, reflecting the buyers' belief that most assets that are offered for sale are of low quality. I analyze the role of market liquidity and beliefs about likelihood of a crisis in amplifying the effect of adverse selection. In the third chapter, I apply the smooth model of decision making under ambiguity to study the equity home bias puzzle. I show that difference in beliefs about perceived uncertainty, characterized by optimism or overconfidence, can significantly contribute to the explanation of the equity home bias observed in the data. I examine how ambiguity about the distribution of asset returns affects equilibrium prices and equity holdings in a two-country CARA-normal setting. All investors possess the same information about the set of possible states and the corresponding returns distribution in each state, but they have different beliefs about the likelihood of these states. In this setting, optimism and overconfidence refer to distorted beliefs about the expected mean and the dispersion of the asset returns distribution, respectively. I analyze and quantify the effects of optimism and overconfidence on asset prices and asset holdings when investors are ambiguity averse. Furthermore, I show that the equity home bias is larger in countries with smaller market capitalization.