What is Foreign Portfolio Investment (FPI)?
Foreign portfolio investment (FPI) involves an investor purchasing foreign financial assets. The transaction of foreign securities generally occurs at an organized formal securities exchange or through an over-the-counter market transaction.
Foreign portfolio investment is becoming increasingly more common as a means of portfolio diversification. Often, FPIs consist of securities and alternative foreign financial assets that are passively held by a foreign investor.
- Generally, foreign portfolio investments consist of securities and alternative foreign financial assets that are passively held by a foreign investor. It involves an investor purchasing foreign financial assets.
- Foreign portfolio investors are normally exposed to increased share price volatility, which increases their risk, and investors expect to receive compensation for the risk they take on.
- Foreign portfolio investors can access equities, bonds, derivatives, mutual funds, and guaranteed investment certificates, among other instruments.
Who Can Make Foreign Portfolio Investments?
Foreign portfolio investing is popular among several different types of investors. Common transactors of foreign portfolio investment include:
- Foreign governments
Benefits of Foreign Portfolio Investment
The primary benefits of foreign portfolio investment are:
1. Portfolio diversification
Foreign portfolio investment provides investors with an easy opportunity to diversify their portfolio internationally. An investor would diversify their investment portfolio to achieve a higher risk-adjusted return, which is ultimately done to help generate alpha.
2. International credit
Investors may be able to access an increased amount of credit in foreign countries, allowing the investor to utilize more leverage and generate a higher return on their equity investment.
3. Access to markets with different risk-return characteristics
If investors are seeking out greater returns, they must be willing to take on greater risk. Emerging markets can offer investors a different risk-return profile.
4. Increases the liquidity of domestic capital markets
As markets become more liquid, they become deeper and broader, and a wider range of investments can be financed. Savers can invest with the assurance that they will be able to manage their portfolio or sell their financial securities quickly if they need access to their savings.
5. Promotes the development of equity markets
Increased competition for financing will lead to the market rewarding superior performance, prospects, and corporate governance. As the market’s liquidity and functionality develop, equity prices will become value-relevant for investors, ultimately driving market efficiency.
Risks of Foreign Portfolio Investment (FPI)
The primary risks faced by a foreign portfolio investor are:
1. Volatile asset pricing
Across international financial markets, some are riskier than others. For example, consider the Deutscher Aktienindex (DAX). The DAX is a stock market index of 30 major German companies trading on the Frankfurt Stock Exchange. The DAX is historically more volatile than the S&P 500 Index.
2. Jurisdictional risk
Jurisdictional risk can result from investing in a foreign country. For example, if a foreign country that you were invested in drastically changes its laws, it could result in a material impact on the investment’s returns.
Moreover, many countries struggle with financial crime, such as money laundering. Investing in countries where money laundering is prevalent increases the jurisdictional risk faced by the investor.
Financial Assets for Foreign Portfolio Investments
The typical financial assets that can be purchased through foreign portfolio investment include equities, bonds, and derivative instruments. These securities can be purchased for many reasons; however, generally, foreign portfolio investment is positively influenced by high rates of return and reduction of risk through geographic diversification.
Policies for Foreign Portfolio Investment
Foreign portfolio investment is inherently volatile, and rigorously regulated financial markets are needed to manage the risk effectively. Furthermore, the financial system must be capable of identifying and mitigating risks for prudent and efficient allocation of foreign or domestic capital flows.
Economic growth and development are enabled by successful financial intermediation and the efficient allocation of credit. Financial systems can maintain their health through the identification and management of business risks. Moreover, the financial system must also withstand economic shocks.
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