The Systemic Effects of Benchmarking

52 Pages Posted: 20 Aug 2015 Last revised: 21 Jan 2017

Diogo Duarte

Florida International University (FIU) - Department of Finance; Boston University - Department of Finance & Economics

Kyounghwan Lee

Boston University - Department of Finance & Economics

Gustavo Schwenkler

Boston University - Department of Finance & Economics

Date Written: August 31, 2015

Abstract

We show that the competitive pressure to beat a benchmark may induce institutional trading behavior that exposes retail investors to tail risk. In our model, institutional investors are different from a retail investor because they derive higher utility when their benchmark outperforms. This forces institutional investors to take on leverage to overinvest in the benchmark. Institutional investors execute fire sales when the benchmark experiences shock. This behavior increases market volatility, raising the tail risk exposure of the retail investor. Ex post, tail risk is only short lived. All investors survive in the long run under standard conditions, and the most patient investor dominates. Ex ante, however, benchmarking is welfare reducing for the retail investor, and beneficial only to the impatient institutional investor.

Keywords: Benchmarking, Institutional investors, retail investors, tail risk, heterogenous agents

JEL Classification: G2, G12, D51, D60

Suggested Citation

Duarte, Diogo and Lee, Kyounghwan and Schwenkler, Gustavo, The Systemic Effects of Benchmarking (August 31, 2015). Available at SSRN: https://ssrn.com/abstract=2646791 or http://dx.doi.org/10.2139/ssrn.2646791

Diogo Duarte

Florida International University (FIU) - Department of Finance ( email )

University Park
11200 SW 8th Street
Miami, FL 33199
United States

Boston University - Department of Finance & Economics ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States

Kyounghwan Lee

Boston University - Department of Finance & Economics ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States

Gustavo Schwenkler (Contact Author)

Boston University - Department of Finance & Economics ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States

HOME PAGE: http://people.bu.edu/gas

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