Foreign capital inflows: direct investment, equity investment, and foreign debt

We develop a two-country stochastic growth model with production, relative price and sovereign default risks. Domestic production and relative price volatilities cause more fluctuations in the agents' portfolio decisions than the volatility of Foreign Direct Investment (FDI) production does. Both the sovereign risk and separability of FDI capital affect the composition of foreign capital inflows in two directions. The direct effect induces substitution of FDI for more Foreign Portfolio Investment (FPI) and foreign borrowing, while the indirect effect encourages FDI due to the increase in FDI's marginal contribution to the foreign agent's welfare after default.FDI; foreign direct investment; foreign equity investment; inelastic debt supply; volatility; economic policy; emerging economies; foreign debt; foreign portfolio investment.