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Asset Prices and Institutional Investors

  • Suleyman Basak
  • Anna Pavlova

We consider an economy populated by institutional investors alongside standard retail investors. Institutions care about their performance relative to a certain index. Our framework is tractable, admitting exact closed-form expressions, and produces the following analytical results. We find that institutions tilt their portfolios towards stocks that compose their benchmark index. The resulting price pressure boosts index stocks. By demanding more risky stocks than retail investors, institutions amplify the index stock volatilities and aggregate stock market volatility and give rise to countercyclical Sharpe ratios. Trades by institutions induce excess correlations among stocks that belong to their benchmark, generating an asset-class effect.

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/aer.103.5.1728
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File URL: http://www.aeaweb.org/aer/data/aug2013/20110249_app.pdf
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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 103 (2013)
Issue (Month): 5 (August)
Pages: 1728-58

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Handle: RePEc:aea:aecrev:v:103:y:2013:i:5:p:1728-58
Note: DOI: 10.1257/aer.103.5.1728
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  1. Lakonishok, Josef, et al, 1991. "Window Dressing by Pension Fund Managers," American Economic Review, American Economic Association, vol. 81(2), pages 227-31, May.
  2. Bengt Holmstrom, 1979. "Moral Hazard and Observability," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 74-91, Spring.
  3. Patrick Bolton & Mathias Dewatripont, 2005. "Contract Theory," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262025760, June.
  4. Zitzewitz, Eric, 2003. "How Widespread Is Late Trading in Mutual Funds?," Research Papers 1817, Stanford University, Graduate School of Business.
  5. Cox, John C. & Huang, Chi-fu, 1989. "Optimal consumption and portfolio policies when asset prices follow a diffusion process," Journal of Economic Theory, Elsevier, vol. 49(1), pages 33-83, October.
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