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Why Do Demand Curves for Stocks Slope Down?

  • Antti Petajisto
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    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 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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    File URL: http://icfpub.som.yale.edu/publications/2458
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    Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number amz2458.

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    Date of creation: 01 May 2004
    Date of revision: 01 Sep 2008
    Handle: RePEc:ysm:somwrk:amz2458
    Contact details of provider: Web page: http://icf.som.yale.edu/

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    1. Joseph Chen & Harrison Hong & Jeremy C. Stein, 2001. "Breadth of Ownership and Stock Returns," NBER Working Papers 8151, National Bureau of Economic Research, Inc.
    2. Franklin Allen, 2001. "Presidential Address: Do Financial Institutions Matter?," Journal of Finance, American Finance Association, vol. 56(4), pages 1165-1175, 08.
    3. Berk, Jonathan B, 1995. "A Critique of Size-Related Anomalies," Review of Financial Studies, Society for Financial Studies, vol. 8(2), pages 275-86.
    4. Barberis, Nicholas & Thaler, Richard, 2003. "A survey of behavioral finance," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 18, pages 1053-1128 Elsevier.
    5. Jonathan B. Berk & Richard C. Green, 2004. "Mutual Fund Flows and Performance in Rational Markets," Journal of Political Economy, University of Chicago Press, vol. 112(6), pages 1269-1295, December.
    6. Franklin Allen, 2001. "Do Financial Institutions Matter?," Center for Financial Institutions Working Papers 01-04, Wharton School Center for Financial Institutions, University of Pennsylvania.
    7. Gale, D. & Allen, F., 1991. "Limited Market Participation and Volatility of Asset Prices," Weiss Center Working Papers 14-91, Wharton School - Weiss Center for International Financial Research.
    8. Amihud, Yakov & Mendelson, Haim, 1986. "Asset pricing and the bid-ask spread," Journal of Financial Economics, Elsevier, vol. 17(2), pages 223-249, December.
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