Kirabaeva, Koralai. 2009. Essays On International Investment Allocation: The Role Of Liquidity,
Asymmetric Information And Beliefs. Doctoral Dissertation, Cornell
University.
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 bias puzzle in a decision-theoretic framework. In the first chapter, I
develop a two-country model that analyzes the composition of capital flows
(direct vs. portfolio) across two countries in the presence of heterogeneity in
liquidity risk and asymmetric information about investment productivity. Direct
investment is characterized by higher profitability and private information
about investment productivity, while portfolio investment provides greater risk
diversification. I demonstrate the possibility of multiple equilibria due to
strategic complementarities in choosing direct investment. I analyze the effect
of an increase in the liquidity risk on the composition of foreign investment.
If there is a unique equilibrium, then higher liquidity risk leads to a higher
level of foreign direct investment (FDI). If, however, there are multiple
equilibria, higher liquidity risk may lead to the opposite effect, a decline of
FDI. In this case, an outflow of FDI is induced by self-fulfilling
expectations. The dual effect of increased liquidity risk on capital flows can
be related to empirically observed patterns of foreign investment during
liquidity crises. Furthermore, my model offers a liquidity-based explanation
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.
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