STOCK MARKET VALUATIONS AND FOREIGN DIRECT INVESTMENT

Abstract

We outline and test two theories of foreign direct investment based on capital market mispricing. The “cheap assets” or “fire-sale” theory considers FDI inflows as the purchase of undervalued host country assets, while the “cheap financial capital” theory views FDI outflows as a natural use of the relatively low-cost capital available to overvalued firms in the source country. The results are consistent with the cheap financial capital theory: 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, especially when capital account restrictions limit cross-country arbitrage.