Week 5 - FDI and Subsidiaries Flashcards
What is the definition of Foreign Direct Investment? (2)
- refers to cross border investment where a resident in one economy has control or a significant degree of influence over an enterprise in another economy
- Typically own at least 10% of the voting stock
List some components of FDI (2)
- Equity capital
- Reinvestment of earnings
Why do firms choose FDI over exporting or franchising? (4)
- Gain proprietary technology and trademarks
- Gain managerial expertise
- Access to economies of scale
- Access to foreign markets rather than relying on indirect methods
What are internalisation advantages of FDI? (3)
- Reducing high enforcement costs
- Ensuring buyer certainty
- Maintaining control over production processes in foreign markets
What are some country specific advantages for FDI? (5)
Access to:
- Natural Resources
- Specialised technologies
- Cheap labour
- avoids trade barriers
- overcomes physical/cultural distance from markets
What is a major disadvantage of FDI?
Requires large and often irreversible investments
How do MNCs select FDI projects?
Based on risk-adjusted performance measures, aiming to improve the overall risk-reward profile of the company’s investment portfolio
How do you calculate the expected return for an FDI project? (2)
E [Rxy] = Wx E(Rx) + (1-Wx)E[Ry)
- Wx and Wy - weights of investments X and Y, E[Rx] and E[Ry] - expected returns for each investment
How do you calculate the variance of an FDI portfolio? (2) (sigma)
Var [Rxy] = W^2xVar[Rx] + W^2Var[Ry] + 2WxWyPx,y σxσy
- σx and σy - standard deviations of investments X and Y, Px,y - correlation between two assets
What is the Sharpe Ratio used for in FDI analysis and what is the formula? (2)
- Used to evaluate the risk adjusted return of an investment portfolio
- SR = E [Ri] - Rf / σi
- E [Ri] - expected return, Rf - risk free rate, σi - standard deviation of returns
How is the Treynor Ratio different from the Sharpe Ratio? (3)
- Another risk-adjusted performance measure that focuses on systematic risk (beta) rather than total risk
- TR = E [Ri] - Rf / βi
- βi - beta of the investment
What is the Beta (β) of an FDI portfolio? (2)
- Measures the systematic risk of an asset relative to the market
- βxy = Wxβx + (1-Wx)βy
What does the Sharpe Ratio tell us about a project? (2)
- Indicates how much additional return is earned for each unit of total risk taken
- Higher Sharpe Ratio = better risk-adjusted returns
How does the Treyner Ratio interpret risk? (2)
- Indicates how much additional return is earned for each unit of systematic risk
- Higher Traynor Ratio = better performance relative to market risk
Why is the TR more appropriate for a diversified portfolio?
Focuses on systematic risk, which remains even after diversification
What is the Global Efficient Frontier?
Represents the set of optimal portfolio that provide the highest return for a given level of risk, considering both domestic and international investments
What is Home Bias in investment?
The tendency of investors to disproportionately allocate their investment to local assets, even when global diversification could improve risk-adjusted returns
How does Home Bias affect investment returns? (2)
- Leads to lower risk-adjusted returns as investor is not fully benefitting from global diversification
- UK investors with a high home bias historically have seen lower returns compared to a global equity portfolio
What are some potential explanations for home bias? (5)
- Information costs - investors know more about local assets
- Capital Controls - Restrictions on the free flow of capital can limit foreign investments
- Currency risk - Investors may avoid international exposure due to concerns over exchange rate fluctuation
- Biases - cognitive biases can lead investors to overvalue local information
- Indirect exposure - local firms may already have international operations
