Asset Pricing with Index Investing

87 Pages Posted: 29 Nov 2014 Last revised: 21 Jul 2020

See all articles by Georgy Chabakauri

Georgy Chabakauri

London School of Economics and Political Science

Oleg Rytchkov

Temple University - Department of Finance

Date Written: July 20, 2020

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 effects 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 investing 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.

Keywords: risk sharing, general equilibrium, index investing, heterogeneous investors, Lucas trees

JEL Classification: G12, D52

Suggested Citation

Chabakauri, Georgy and Rytchkov, Oleg, Asset Pricing with Index Investing (July 20, 2020). Journal of Financial Economics (JFE), Forthcoming, Fox School of Business Research Paper No. 15-051, Available at SSRN: https://ssrn.com/abstract=2531753 or http://dx.doi.org/10.2139/ssrn.2531753

Georgy Chabakauri

London School of Economics and Political Science ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

HOME PAGE: http://personal.lse.ac.uk/CHABAKAU/

Oleg Rytchkov (Contact Author)

Temple University - Department of Finance ( email )

Fox School of Business and Management
Philadelphia, PA 19122
United States

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