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.

Keywords: Price elasticity, demand-based asset pricing

JEL Classification: G11, G12