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Asset Pricing with Index Investing

68 Pages Posted: 29 Nov 2014 Last revised: 16 Dec 2016

Georgy Chabakauri

London School of Economics and Political Science

Oleg Rytchkov

Temple University - Department of Finance

Date Written: July 5, 2016

Abstract

We provide a theoretical analysis of how index investing affects capital market equilibrium. We consider a dynamic exchange economy with heterogeneous investors and two Lucas trees and find that the introduction of index trading increases volatilities and correlation of stock returns. Contrary to conventional wisdom, these effects mainly result from improved risk sharing rather than from lockstep trading of stocks implied by indexing. Despite the residual market incompleteness, index investing increases welfare of investors previously excluded from financial markets so that it becomes close to its first-best level in the economy in which all investors trade individual assets.

Keywords: asset pricing, 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 5, 2016). 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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