Asset Pricing: Market Mispricing and Limits to Arbitrage
Paper Session
Friday, Jan. 5, 2024 8:00 AM - 10:00 AM (CST)
- Chair: Christian Opp, University of Rochester
Pension Fund Flows, Exchange Rates, and Covered Interest Rate Parity
Abstract
Frequent, yet uninformed, fund flows in Chilean pension plans generate substantial trading in currency markets due to the high allocation to international securities. These non-fundamental flows have a significant impact on the Chilean peso, which is estimated to have a relatively low price elasticity of 0.81. Hedging by the banking sector propagates the price pressure to currency forward markets and results in violations of the covered interest rate parity. Using trading data and bank balance sheet data, we confirm that regulatory requirements and banks' risk bearing constraints create limits of arbitrage.Why is Asset Demand Inelastic?
Abstract
In many frictionless asset-pricing models, investor demand curves are virtually flat. Koijen and Yogo (2019), in contrast, estimate surprisingly inelastic demand. In this paper, we identify the source of this discrepancy and show that low demand elasticity estimates for individual stocks are not puzzling if price movements are not entirely associated with short-term discount rate changes. In a standard portfolio choice framework, we show that the demand elasticity is primarily determined by how expected returns impact investor portfolio weights in response to price movements. If prices only drop due to next-period discount rates (as most theoretical models assume), we show that demand elasticity will be high. But, if price movements are not entirely driven by next-period expected returns (as empirical estimates of elasticity measure), demand will be inelastic. Consistent with inelastic demand estimates, we find evidence of weak reversals or momentum at different horizons.Discussant(s)
William Diamond
,
University of Pennsylvania
Amy Huber
,
University of Pennsylvania
Daniel Neuhann
,
University of Texas
JEL Classifications
- G1 - General Financial Markets