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Why Do Demand Curves for Stocks Slope Down?

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  • Petajisto, Antti

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 be steep enough to match the magnitude of many empirical findings, including the price effects for stocks entering or leaving the S&P 500 index.

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  • Petajisto, Antti, 2009. "Why Do Demand Curves for Stocks Slope Down?," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 44(05), pages 1013-1044, October.
  • Handle: RePEc:cup:jfinqa:v:44:y:2009:i:05:p:1013-1044_99
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    Cited by:

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    2. Elliott, William B. & Songur, Hilmi, 2016. "The role of arbitrage risk on the elasticity of demand: New evidence from 100% secondary equity offerings," Finance Research Letters, Elsevier, vol. 19(C), pages 165-172.
    3. Ľuboš Pástor & Robert F. Stambaugh, 2012. "On the Size of the Active Management Industry," Journal of Political Economy, University of Chicago Press, vol. 120(4), pages 740-781.
    4. Gagnon, Louis & Andrew Karolyi, G., 2010. "Multi-market trading and arbitrage," Journal of Financial Economics, Elsevier, pages 53-80.
    5. Hau, Harald, 2014. "The exchange rate effect of multi-currency risk arbitrage," Journal of International Money and Finance, Elsevier, vol. 47(C), pages 304-331.
    6. Hacıbedel, Burcu, 2014. "Does investor recognition matter for asset pricing?," Emerging Markets Review, Elsevier, vol. 21(C), pages 1-20.
    7. Hong, Harrison & Kacperczyk, Marcin, 2009. "The price of sin: The effects of social norms on markets," Journal of Financial Economics, Elsevier, vol. 93(1), pages 15-36, July.
    8. Terence C. Burnham & Harry Gakidis & Jeffrey Wurgler, 2017. "Investing in the Presence of Massive Flows: The Case of MSCI Country Reclassifications," NBER Working Papers 23557, National Bureau of Economic Research, Inc.
    9. Robert F. Stambaugh, 2014. "Investment Noise and Trends," NBER Working Papers 20072, National Bureau of Economic Research, Inc.
    10. Terence C. Burnham & Harry Gakidis & Jeffrey Wurgler, 2017. "A Flexible and Customizable Method for Assessing Cognitive Abilities," Working Papers 17-10, Chapman University, Economic Science Institute.

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