institutional sector is less developed. Foreign investors can speed the process. Foreign investors may introduce financial innovations, such as sophisticated trading arrangements and investment techniques, which may be quickly adopted and further developed by domestic financial institutions. At an early stage of Spanish debt market development, domestic institutional investors were a rather unimportant group, but grew with development of the debt market. Foreign investors have played an important role in introducing financial innovations into the Spanish market. The innovations were quickly copied and extended by domestic banks and asset managers. One example of such innovations is the introduction of guaranteed return mutual funds.

Locally incorporated foreign-owned insurers could bring additional and possibly innovative marketing and product competition to the national market that can deepen and broaden the domestic financial services marketplace. Foreign insurers often are particularly good at risk pricing, a vital aspect of the insurance business. Foreign insurers bring additional capacity to the insurance business, which helps businesses and individuals to transform their property, liability, income and other risk exposures to suit the liquidity, security and other risk profiles they desire. As foreign-owned insurers are often part of much larger international groups, their risk pooling activities might be particularly helpful, thus offering the potential for greater pricing and investment stability. By bringing innovative and more efficient means of gathering and evaluating information, foreign insurers aid capital allocation.<sup>2 7</sup>

# 2.3. **Risks associated with foreign investors**

Incomplete information can make lenders Prone to engage in herding behavior, causing sudden market movements and volatility. Since foreign investors may have an information disadvantage as compared with domestic investors, their presence can increase the extent of herding.<sup>2 9</sup> Kim and Wei, 1999 provide evidence consistent with models suggesting information disadvantages of foreign investors.

Some theoretical studies show that when international investors can choose from many risky foreign investments and face a fixed cost of information about each country, well-diversified investors may have relatively little incentive to acquire information about all the countries in which they invest.<sup>30</sup> 27 Skipper, 1997.

> 28 Herding behavior is not necessarily "irrational". The models of rational herding are typically built on one of three effects: (i) payoff extemalities, where the payoffs to an agent adopting an action increase in the number of other agents adopting the same action; (ii) principal-agent models, where managers prefer to "hide in the herd" not to be easily evaluated, or to "ride the herd" to prove their quality; and (iii) models of information cascades, where agents infer information from the actions of others and optimally act alike.

> 29 See Kim and Wei, 1999 for the Korean case. Froot, O'Connell and Seasholes, 1999 provide evidence of very strong trend following in international inflows. Kaminsky, Lyons and Schmukler, 1999 find Latin America equity funds tend to use positive feedback strategies in both crisis and non-crisis periods. However, Choe, Kho and Stulz, 1999 find that foreign investors as a group engaged in positive feedback trading before the crisis in Korea, but during the crisis feedback trading mostly disappeared.

> 30 For example, see Calvo and Mendoza, 1997. In their model, international investors experience less incentive to gather information when financial markets in many countries are being liberalized at the same time. In this kind of model, financial market liberalization and the presence of foreign investors increase

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