DP17454 Granular Investors and International Bond Prices: Scarcity-Induced Safety
Leveraging on a unique dataset of corporate bonds held in euro area, we study the role of granular and heterogenous investors’ demand on currency pricing. Due to their mandate insurance and pension funds exhibit home asset and currency biases, while mutual funds display neither. Motivated by this segmentation, we identify and estimate the role of investor demand for euro-dollar return differentials (hedged and unhedged) for the same security and issuer. These differentials decline following the increase in ECB asset purchases of euro securities: the scarcity induced by the drain in supply reduced the required yields on euro securities, eroding dollar convenience yield. We build a two country model with investors, exhibiting heterogenous reference-dependent preferences and solving dynamic portfolio optimization: the degree of loss aversion explains the demand of some investors for less risky securities and the decline in the required yields following a drain in their supply. A duration extraction channel rationalizes the rebalance dynamic, observed in the data, through the lens of the model.