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Asset pricing with index investing

Author

Listed:
  • Chabakauri, Georgy
  • Rytchkov, Oleg

Abstract

We theoretically analyze how index investing affects financial markets using a dynamic exchange economy with heterogeneous investors and two Lucas trees. We identify two ef- fects of indexing: lockstep trading of stocks increases market volatility and stock return correlations but reduction in risk sharing decreases them. Overall, indexing decreases market volatility but has an ambiguous effect on the correlations. Also, index invest- ing decreases an investor’s welfare, but indexing by other investors partially offsets the loss. When the introduction of index trading opens financial markets for new investors, the improved risk sharing makes market returns more volatile and stock returns more correlated.

Suggested Citation

  • Chabakauri, Georgy & Rytchkov, Oleg, 2021. "Asset pricing with index investing," LSE Research Online Documents on Economics 105749, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:105749
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    File URL: http://eprints.lse.ac.uk/105749/
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    References listed on IDEAS

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    Cited by:

    1. Buffa, Andrea M. & Hodor, Idan, 2023. "Institutional investors, heterogeneous benchmarks and the comovement of asset prices," Journal of Financial Economics, Elsevier, vol. 147(2), pages 352-381.
    2. Coles, Jeffrey L. & Heath, Davidson & Ringgenberg, Matthew C., 2022. "On index investing," Journal of Financial Economics, Elsevier, vol. 145(3), pages 665-683.

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    More about this item

    Keywords

    indexing; risk sharing; Lucas trees; general equilibrium; heterogeneous investors; Paul Woolley Centre;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets

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