Describe portfolio investments and FDI. How do they differ and why is it important to distinguish between them?
Foreign portfolio investments (FPI) and foreign direct investments (FDI) are two commonly used and at times easily confused phrases. Foreign portfolio investments refer to investments in financial assets in a foreign country. These financial instruments include instruments like stocks and bonds. Investors love to invest in such instruments in order to diversify and hedge their portfolios. For example, Brexit has caused European banks to shed their values significantly and some international fund managers have already started purchasing these banks to diversify their portfolio and take advantage of attractive stock valuations. On the other hand, foreign direct investment refers to the establishment of direct business interest in a foreign country. For instance, the establishment of a business dealing in mining operations or even in manufacturing operations in a foreign country is considered to be a foreign direct investment and not foreign portfolio investment. Foreign direct investments are popular in countries with stable business environment and strong GDP growth. When making the foreign investments, the international investors must consider various economic environment factors of the country in focus. Additionally, the investors must look into the risk factors or other factors in the investment environment that are no economic factors. Such risk factors include the foreign exchange risk, which relates to the volatility in the exchange rates. Other such factors of interest include the political risk or the risks of political instability or even political interference in the business of interest (Hattari & Rajan, 2011).
There are fundamental differences between foreign direct investment and foreign portfolio investment that the reader ought to understand. Firstly, foreign direct investment offers control over the business while FPI does not. Secondly, FDI comes with long-term investment strategies in which the investor seeks to get returns in the long-term while FPI involves quick realization of the profit or return on the investment. Thirdly, the FDI is considerably difficult to liquidate while FPIs are easy to liquidate since the financial instruments are sold on exchanges. Lastly, FPIs are considerably easier to invest in for the average investor since there are no hefty capital requirements as compared to the foreign direct investments. Understanding these differences is important in public finance as the differentiation becomes fundamentally important in public finance accounting. To the investor, it is important in planning on which of the two strategies to consider depending the understanding of the foreign country’s risk as explained above as well as the investors’ interests.
Question Two
The BOP accounting system refers to an accounting system that is designed to follow through the buy and sell transactions between countries by individuals, businesses, and the government involved. The system comprises four main accounts. These include the current account that records and captures data on exports and imports of merchandise, services, gifts, and investment income. The second is the capital account that captures all capital transactions including the purchases and sale of assets. It is from the capital account that the FDI and FPI are captured. The third is the official reserves account that takes care of the records of foreign currency reserves held by the government. Lastly, there is the errors and omissions account that captures any required adjustments to BOP from all other accounts (Economics Online, 2016).
The errors and omissions account is important owing to the possibilities of errors and omissions in the measurement of the items of the capital and current accounts. The errors are majorly caused by lagging in individual or business transactions that are not recorded at the right time concerning the time of actual payments. The errors may also result from valuation errors. Lastly, the errors may be as a result of a balance of payments error that may result from errors in the measurement and recording of volumes. In both valuation and volume measurements, the items may either be overestimated or may be underestimated. Notably, understanding the BOP accounting and concept would help the international business community in understanding how their activities impact on the nation in addition to understanding the importance of measuring, recording, and reporting all international business transactions correctly (Economics Online, 2016).
Question Three
The foreign exchange market thrives on the flow of information. This information influences the changes in foreign exchange rates. The information reaches individuals and business persons through the communications and technology channels and it for this reason that the technologies are considered to be very important in the determination of the rates (Rime, 2003). In the current volatile and turbulent times in the financial markets, information plays a critical role in determining investors who make money from the stock market.
If the technologies of the past decades were eliminated, the flow of information would be greatly affected. The implications would result in market inefficiencies that allow governments and scrupulous business persons to fix the exchange rates as and when they feel like changing them to their favor. Retail and novice investors would not have access to computer generated investment analysis to make their investments. With technology, people who have no prior background on finance are now able to make investments using automated trading. Additionally, it would be difficult for countries to transact business owing to the market inefficiencies. Trading in foreign currencies would be difficult, and the organizations would also find it difficult to engage with other organizations in business. In essence, foreign direct investments and foreign portfolio investments would be highly affected and probably little in volumes and activity (Rime, 2003).
References
Economics Online. (2016). Balance of payments. Retrieved from http://www.economicsonline.co.uk/Managing_the_economy/Balance_of_payments.html
Hattari, R., & Rajan, R. S. (2011). How different are FDI and FPI flows? Does distance alter the composition of capital flows? Retrieved from http://s3-ap-southeast-1.amazonaws.com/asia-first/researches/web_link/5cc3353548c38d14257c624964657023.pdf
Rime, D. (2003). New electronic trading systems in foreign exchange markets. New Economy Handbook, 469504.
