Foreign Direct Investment vs Foreign Portfolio Investment ∗

The paper develops a model of foreign direct investments (FDI) and foreign portfolio investments (FPI). FDI is characterized by hands-on management style which enables the owner to obtain relatively refined information about the productivity of the firm. This superiority, relative to FPI, comes with a cost: a firm owned by the relatively well-informed FDI investor has a low resale price because of a "lemons " type asymmetric information between the owner and potential buyers. The model can explain several stylized facts regarding foreign equity flows, such as the larger ratio of FDI to FPI inflows in developing countries relative to developed countries, and the smaller volatility of FDI net inflows relative to FPI net inflows