Asset Prices and Institutional Investors

62 Pages Posted: 17 Mar 2010 Last revised: 27 Aug 2012

Suleyman Basak

London Business School; Centre for Economic Policy Research (CEPR)

Anna Pavlova

London Business School; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: August 24, 2012

Abstract

Empirical evidence indicates that trades by institutional investors have sizable effects on asset prices, generating phenomena such as index effects, asset-class effects and others. It is difficult to explain such phenomena within standard representative-agent asset pricing models. In this paper, we consider an economy populated by institutional investors alongside standard retail investors. Institutions care about their performance relative to a certain index. Our framework is tractable, admitting exact closed-form expressions, and produces the following analytical results. We find that institutions optimally tilt their portfolios towards stocks that comprise their benchmark index. The resulting price pressure boosts index stocks, while leaving nonindex stocks unaffected. By demanding a higher fraction of risky stocks than retail investors, institutions amplify the index stock volatilities and aggregate stock market volatility, and give rise to countercyclical Sharpe ratios. Trades by institutions induce excess correlations among stocks that belong to their benchmark index, generating an asset-class effect.

Keywords: Asset pricing, indexing, institutions, money management, general equilibrium

JEL Classification: G12, G18, G29

Suggested Citation

Basak, Suleyman and Pavlova, Anna, Asset Prices and Institutional Investors (August 24, 2012). AFA 2011 Denver Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1572342 or http://dx.doi.org/10.2139/ssrn.1572342

Suleyman Basak

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom
44 (0)20 7000 8256 (Phone)
44 (0)20 7000 8201 (Fax)

HOME PAGE: http://www.suleymanbasak.com

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Anna Pavlova (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom
+44 20 7000 8218 (Phone)

HOME PAGE: http://faculty.london.edu/apavlova

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

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