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Demand System Asset Pricing

Paper Session

Sunday, Jan. 8, 2023 8:00 AM - 10:00 AM (CST)

Sheraton New Orleans, Napoleon B & C
Hosted By: American Finance Association
  • Chair: Ralph Koijen, University of Chicago

Do Subjective Growth Expectations Matter for Asset Prices?

Aditya Chaudhry
,
University of Chicago

Abstract

I find that the causal effect of subjective growth expectations on asset prices is far smaller than standard models suggest. To quantify this causal effect, I construct an asset demand model in which Bayesian investors learn from analysts and other signals. A 1% rise in annual investor growth expectations raises price only 7 to 16 basis points, an order of magnitude less than in standard models. This small causal effect arises from the limited passthrough of beliefs to asset demand, and is consistent with small price elasticities of demand. To reconcile this small causal effect with the strong correlation of growth expectations and prices, I provide evidence of reverse causality. Using flow-induced trading to instrument for prices, I find that prices cause growth expectations.

The Making of Momentum: A Demand-System Perspective

Paul Huebner
,
University of California-Los Angeles

Abstract

I develop a framework to quantify which features of investors’ trading strategies lead to momentum in equilibrium. Specifically, I distinguish two channels: persistent demand shocks, capturing underreaction, and the term structure of demand elasticities, representing an intensity of arbitrage activity that decreases with investor horizon. I introduce both aspects of dynamic trading into an asset demand system and discipline the model using the joint behavior of portfolio holdings and prices. I estimate the demand of institutional investors in the U.S. stock market between 1999 and 2020. On average, investors respond more to short-term than longer-term price changes: the term structure of elasticities is downward-sloping. My estimates suggest that this channel is the primary driver of momentum returns. Moreover, in the cross-section, stocks with more investors with downward-sloping term structures of elasticities exhibit stronger momentum returns by 7% per year.

On the Estimation of Demand-Based Asset Pricing Models

Philippe van der Beck
,
Swiss Federal Institute of Technology Lausanne (EPFL) and Swiss Finance Institute

Abstract

A growing literature uses portfolio holdings data to quantify the impact of investor demand on equilibrium prices via counterfactual experiments. The key parameter in relating demand and equilibrium prices is investors’ elasticity of demand with respect to the price. Unlike previous studies, which rely on cross-sectional estimates in levels, this paper proposes estimating elasticities from investors’ trades, that is changes in their portfolios. I use demand shocks from mutual fund flows as an instrument to address the endogeneity of trades and prices. Using the estimation in changes along with the flow-based instrument I find that elasticities are 4 times larger than what previous estimates suggest. Estimation over different trading horizons furthermore shows that investors become more elastic in the long run. The results suggest that the impact of demand shocks on equilibrium prices is smaller than previously estimated and partly reverts over time.

What Drives Stock Prices in a Bubble?

Weihua Chen
,
Shanghai Stock Exchange
Shushu Liang
,
Harvard University
Donghui Shi
,
Shanghai Stock Exchange

Abstract

To shed light on the formation, expansion, and deflation of bubbles, we study how the cross section of stocks evolves during the 2015 Chinese stock market bubble. Using data on administrative account-level stock holdings covering a representative sample of 18 million retail investors and all institutional investors, we estimate a structural model of heterogeneous investor demand. The model allows us to attribute variation in stock returns to changing stock characteristics, changing investor preferences or beliefs, and the entrance of new investors. Improved stock fundamentals are initially key, accounting for 21% of the variance in cross-sectional stock returns during the formation of the bubble. In the expansion phase of the bubble, the entrance of new investors plays an important role, explaining 43% of the cross-sectional variance during the phase. Finally, the deflation phase is characterized by shifts in preferences or beliefs among existing retail investors, accounting for 25% of the cross-sectional variance in the period. We highlight the ways in which our structural model quantifies the forces in Kindleberger (1978)’s classic narrative.
JEL Classifications
  • G1 - General Financial Markets