Research

We develop and estimate a new asset pricing model to study how global institutional investment affects global and local risk premia in 38 markets. By investing across countries, institutional investors facilitate international risk-sharing between home-biased retail investors. This risk-sharing channel depends on the scope of institutional investors’ mandate, their risk bearing capacity and substitutability between securities from different countries. Securities earn a global market risk premium as well as an institutional local risk premium. In addition, securities that are not invested by institutions earn a retail local risk premium. The average annual institutional local risk premium is 2.76% in developed markets and 6.27% in emerging markets. The average annual retail local risk premium is 1.71% in developed markets and 2.65% in emerging markets. Higher firm-level global institutional ownership reduces the cost of capital in emerging markets.

We study how firms’ ESG performance affects domestic and foreign institutional investment and rebalancing. Country-by-country post-double-LASSO estimates reveal heterogeneous marginal effect of ESG on firm-level institutional ownership. At the institution-firm level, institutions exhibit a novel form of home bias: tilting towards high-ESG firms only when these firms are domestic. Institutions are more patient towards high-ESG firms after negative past performance but the mitigation effect is significantly weaker for foreign firms and disappears during distressed episodes.

We exploit the increasing availability of international stock holdings data to examine ownership by different stakeholders in 46 markets. Home bias varies across countries, investor types, and is still much higher in emerging markets (EMs). Institutions have become more global but remain underdiversified. The country effect in institutional ownership of EM stocks is large and of similar economic significance as country factors in explaining EM stock returns. Institutions of different types and domicile continue to show strong preference for large firms but exhibit significant differences for the other firm characteristics. The preference of foreign institutions for cross-listed firms continues and is stronger in EMs. The firm characteristics that matter most for US institutions vary significantly across markets and especially in EM countries. Retail investors are mostly present in small and liquid firms.

We propose an explanation for default risk linkages based on a Lucas model with across independent debt-financed borrowers. The transmission mechanism is that variation in the size of a borrower impacts the default decision for all borrowers. If a negative shock hits one borrower’s fundamentals, the other borrower becomes a larger player in the economy and thus bears more systematic risk. The resulting higher risk premium increases the cost of debt and tilts that borrower’s decision towards default, thereby increasing its default risk and equity volatility. This effect is particularly strong for borrowers with greater rollover needs. Our model helps better understand co-movement in risk premia, default probabilities, and equity volatility across fundamentally-unrelated borrowers.