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Why do portfolio choice models predict inelastic demand?

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  • Davis, Carter
  • Kargar, Mahyar
  • Li, Jiacui

Abstract

Classical asset pricing models predict that optimizing investors exhibit extremely high demand elasticities, while empirical estimates are significantly lower—by three orders of magnitude. To reconcile this disparity, we introduce a novel decomposition of investor demand elasticity into two key components: “price pass-through”, which captures how price movements forecast returns, and “unspanned returns”, reflecting a stock’s lack of perfect substitutes. In a factor model framework, we show that unspanned returns become significant when models include “weak factors”. Classical models overestimate demand elasticity by assuming both very low unspanned returns and high price pass-throughs, assumptions that are inconsistent with empirical evidence.

Suggested Citation

  • Davis, Carter & Kargar, Mahyar & Li, Jiacui, 2025. "Why do portfolio choice models predict inelastic demand?," Journal of Financial Economics, Elsevier, vol. 172(C).
  • Handle: RePEc:eee:jfinec:v:172:y:2025:i:c:s0304405x25001047
    DOI: 10.1016/j.jfineco.2025.104096
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    Keywords

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    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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