Why Do Demand Curves for Stocks Slope Down?
AbstractRepresentative 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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Bibliographic InfoPaper provided by Yale School of Management in its series Yale School of Management Working Papers with number amz2458.
Date of creation: 01 May 2004
Date of revision: 01 Sep 2008
demand curves for stocks; delegated portfolio management; equilibrium mispricing; index premium;
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