International investment theory explains the flow of investment capital into and out of a country by investors who want to maximize the return on their investments. One of the major factors that influence international investment is the potential return on alternative investments in the home country or other foreign markets.
International investment theory is largely determined by the opportunity cost of investment. Opportunity cost is a financial term that refers to the cost you face when picking one investment instead of another that might be more profitable in the long run. International investors compare various investment alternatives and select the opportunity that is likely to maximize returns.
Foreign Portfolio Investment
Foreign portfolio investment is passive foreign investment where investors do not directly participate in the investment in the foreign country. Instead, investors put their money into foreign securities and other investments to earn interest or dividends.
Foreign Direct Investment
Foreign direct investment is the other part of international investment theory and is an active investment in a foreign country. Instead of investing in securities, investors directly build factories or gain controlling interest in foreign businesses to earn profits. An investor may take a bigger risk with a direct investment versus a portfolio investment because that investor will have an overseas business that she must later sell, potentially at a loss depending on market conditions at the time.
Theories of FDI
In general, it is helpful to look at FDI theories as an attempt to answer the "who, what, when, where, why and how" of a particular investment, and to determine whether the economic factors involved justify making foreign investment. To understand FDI, it may help to first seek to understand why an investor would choose to invest abroad rather than either outsourcing production to an existing firm.
To answer the questions of FDI, international investment theory draws on the OLI paradigm. OLI stands for Owner, Location, Internalization. Also called the eclectic paradigm, the OLI paradigm analyzes international investment from the perspective of ownership, location and the firm’s internalization. Internalization refers to the firm's ability to gain first-mover advantage in a new market, and therefore have a competitive edge. Investors put a great deal of thought into determining whether an international investment makes more sense than one that is more domestic in nature, putting serious time into researching each approach and working out which one is the most economically advantageous.