Stock Market Misvaluation and Foreign Direct Investment in the USA - a Cointegrating Relationship

Abstract: The dynamics of misvaluation and Foreign Direct Investment (FDI) have long been debated in light of the efficient market hypothesis. Still, the existence of misvaluation in itself raises the eyebrows of economists as it would entail the possibility of cross-border arbitrage. Consequently, within the debate trying to enlighten the matter, the primary purpose of this thesis is to investigate the dynamics between FDI and misvaluation on the US equity market between 1950 and 2014. More specifically, it aims to examine the presence of fire-sales in periods of undervaluation and the possibility of stock market predictability by examining foreign investor’s reaction to market misvaluation. To carry this out, a misvaluation proxy is estimated and regressed together with FDI within a Vector Error Correction Model (VECM) framework. Consistent with fire-sale FDI hypothesis, we find that foreign investors respond positively to undervaluation in the short-run. In addition, we find that investors also react profitably in the short-run by investing in periods when equity is undervalued and liquidate in periods when equity is overvalued. In the long-run however, FDI doesn’t respond to misvaluation.