Interest Rates and Institutional Investors’ Preferences for Risk

Abstract

We analyze the effect of different interest rate environments on the institutional investors’ preferences towards risk using data on their holdings from 13f filings. We find strong empirical evidence for the predictions Rajan (2006) on how different interest rate characteristics affect institutional investors’ preferences for risk. First, in low interest rate environment, institutional investors prefer riskier stocks, especially those with higher systematic, rather than idiosyncratic, risk. Second, institutional investors migrate to stocks with high systematic and medium idiosyncratic risk in decreasing interest rate environments. Third, decreases in the interest rate level have statistically and economically more important effects on institutional investors’ preferences towards risk than increases in the interest rate level. Fourth, the persistence or volatility of interest rate do not seem to affect institutional investors’ preferences for stocks with different risk characteristics. Fifth, long term interest rate expectations do not significantly alter institutional investors’ preferences toward risk. These results hold for quasi-indexers and dedicated investors but not for transient investors due to their shorter investment horizons.