Academic journal article Multinational Business Review

Assessing the Effect of Investment Barriers on International Capital Flows Using an Expert-Driven System

Academic journal article Multinational Business Review

Assessing the Effect of Investment Barriers on International Capital Flows Using an Expert-Driven System

Article excerpt

ABSTRACT: The analytic hierarchy process (AHP) is an expert-driven system that has been applied to numerous fields but has yet to be applied to portfolio selection. This study shows how the AHP can be modeled to effectively assess barriers to cross-border investments. It demonstrates that it is capable of effectively contributing to the selection of an optimal investment portfolio (OIP), herein a diversified portfolio composed of national markets where barriers to capital flows are least likely to adversely affect its return.


The underlying theoretical basis of diversification formalized in Markowitz's Portfolio Theory and the Capital Asset Pricing Model has been well documented in finance literature. International diversification enables investors to reduce the unsystematic risk of investing in one economy. Business cycles do not happen uniformly across countries. When one country is experiencing rapid growth, another may be in a recession. By investing across countries, investors should logically reduce part of the cyclical fluctuations in their portfolios that arise from the domestic business cycle. Such investors will be exposed to systematic risk related to the global economy.

In spite of the theoretical and matter-of-fact groundings of international diversification, many studies have demonstrated that investors hold portfolios that consist nearly exclusively of domestic assets. This violation of standard theories of portfolio choice is known as the "international diversification puzzle." So why do investors seem to have this bias in favor of securities of their home country? Standard models of optimal portfolio choice cannot rationalize this pattern of asset holdings, even in the presence of unhedged foreign exchange risk.

Obviously many factors can constrain the flow of capital movements across national boundaries. Various methodologies referencing different barriers to capital movements have been employed to explain investors' bias in favor of domestic securities, but the results remain clearly inconclusive. This study is not another explanation for this international diversification puzzle.

Rather, it advocates-to those who want to try a different approach to this problem-a completely different strategic formulation. This study shows that the main benefit of the analytic hierarchy process (AHP) is that it provides decision makers with a method to structure complex problems into the simpler form of a hierarchy of factors (herein, barriers to international capital flows) and of alternatives that can be more easily identified and evaluated. This tool can be used either as a stand-alone decision making model for the decision makers who do not want to ignore expertise within the ranks of their corporations and/or as an effective supplemental tool to traditional models. Experience gained in the field can certainly not be ignored, especially considering that the more traditional models have yet to effectively address the problem.

First, current finance literature has been searched to identify the most significant barriers to international capital flows. These barriers were then submitted for review to a sample of international investment experts operating in the New York metropolitan area. Using their experience in foreign markets, they identified the most formidable of these barriers by comparing them to each other and in terms of their impact on returns in a given sample of countries.

Although a careful attempt has been made in choosing these countries, it is important to note that what is central to this study is not the sample of countries included for the purpose of illustrating this procedure. As each portfolio manager has a different set of countries in mind, what is most important is the methodology underlying the AHP and its ability to incorporate the knowledge of various experts during the identification and selection process that ultimately generates the long-term optimal investment portfolio (OIP). …

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