Institutional Investment and International Risk-sharing

Abstract

This paper proposes a new channel for local risk premia in international stocks based on investor underdiversification. Holdings data reveal two facts. First, retail investors display near-perfect home bias while institutions are globally diversified. Second, institutions substantially underdiversify within each market. Institutions' imperfect cross-market hedging generates an institutional local premium, while their limited investment scope leaves residual risk, generating a retail local premium. These premia average 2.2% and 2.5% across 21 developed markets and 3.5% and 4.5% across 20 emerging markets. Unlike the investability channel, local risk premia persist even when markets are fully open to foreign investors.

Senior Lecturer of Finance