Chapter 10

International Investment

Abstract

This chapter applies some basic ideas of modern finance to understand and analyze the incentives for international investment. It first looks at portfolio diversification, a motive that leads to the two-way flows of capital between countries, showing that investors are concerned with return on investment and also risk attached to the investment, with diversification as a means to reduce risk. Simple examples demonstrate the effects of diversification. Both systematic and nonsystematic risks are defined and explained. The chapter then delves into reasons for the fact that investors have a bias in favor of domestic assets despite expected gains from diversification; various alternatives are considered. ...

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