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Why Do Demand Curves for Stocks Slope Down?

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  • Antti Petajisto
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    Abstract

    Representative agent models are inconsistent with existing empirical evidence for steep demand curves for individual stocks. This paper resolves the puzzle by proposing that stock prices are instead set by two separate classes of investors. While the market portfolio is still priced by individual investors based on their collective risk aversion, those individual investors also delegate part of their wealth to active money managers who use that capital to price stocks in the cross-section. In equilibrium the fee charged by active managers has to equal the before-fee alpha they earn; this endogenously determines the amount of active capital and the slopes of demand curves. A calibration of the model reveals that demand curves can indeed be steep enough to match the magnitude of many empirical findings, including the price effects for stocks added to (or deleted from) the S&P 500 index.

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    File URL: http://icfpub.som.yale.edu/publications/2458
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    Bibliographic Info

    Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number amz2458.

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    Date of creation: 01 May 2004
    Date of revision: 01 Sep 2008
    Handle: RePEc:ysm:somwrk:amz2458

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    Web page: http://icf.som.yale.edu/
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    Related research

    Keywords: demand curves for stocks; delegated portfolio management; equilibrium mispricing; index premium;

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    1. Amihud, Yakov & Mendelson, Haim, 1986. "Asset pricing and the bid-ask spread," Journal of Financial Economics, Elsevier, vol. 17(2), pages 223-249, December.
    2. Jonathan B. Berk & Richard C. Green, 2002. "Mutual Fund Flows and Performance in Rational Markets," NBER Working Papers 9275, National Bureau of Economic Research, Inc.
    3. Allen, F. & Gale, D., 1991. "Limited Market Participation and Volatility of Asset Prices," Weiss Center Working Papers 2-92, Wharton School - Weiss Center for International Financial Research.
    4. Joseph Chen & Harrison Hong & Jeremy C. Stein, 2001. "Breadth of Ownership and Stock Returns," NBER Working Papers 8151, National Bureau of Economic Research, Inc.
    5. Franklin Allen, 2001. "Presidential Address: Do Financial Institutions Matter?," Journal of Finance, American Finance Association, vol. 56(4), pages 1165-1175, 08.
    6. Franklin Allen, 2001. "Do Financial Institutions Matter?," Center for Financial Institutions Working Papers 01-04, Wharton School Center for Financial Institutions, University of Pennsylvania.
    7. Berk, Jonathan B, 1995. "A Critique of Size-Related Anomalies," Review of Financial Studies, Society for Financial Studies, vol. 8(2), pages 275-86.
    8. Nicholas Barberis & Richard Thaler, 2002. "A Survey of Behavioral Finance," NBER Working Papers 9222, National Bureau of Economic Research, Inc.
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