Asset Demand Systems in Macro-Finance.

• Author: Koijen, Ralph S. J.

Every asset pricing model starts with assumptions about investors' preferences, beliefs, and constraints, and firms' technology or cash flows. Market equilibrium requires that investors' asset demands be equal to the supply of various assets. Thus, asset demand systems play a critical role in determining asset prices.

In recent years, the availability of portfolio-holdings data and progress on longstanding identification challenges have revealed an important fact: asset demand for individual stocks, the aggregate stock market, government and corporate bonds, and exposure to common risk factors are much less elastic than standard asset pricing models predict. The large price reactions around events such as index additions and quantitative easing can only be explained by low-demand elasticities.

Many questions in financial economics and in the policy sphere require a well-specified asset demand system to understand how a shift in demand for specific assets or how a group of investors will affect asset prices. Examples include: How much of the secular decline in real interest rates is explained by the safe asset demand of foreign and wealthy investors? What is the convenience yield on US long-term bonds and equities? What is the impact of socially responsible investing or tighter capital regulation on the cross-section of corporate bonds and equities?

Here we summarize our research that uses a demand system approach to better understand the US stock market, the euro-area government bond market, and international bond and equity markets.

Asset Demand Is Surprisingly Inelastic

If asset supply is fixed in the short run, the average demand elasticity for a group of investors can be estimated through an exogenous demand shock to another group of investors. A classic example is an addition or deletion on the S&P 500 index. (1) Passive mutual funds and, to a lesser degree, active investors benchmarked to an index experience a demand shock when a stock is added to the index. This demand shock is a shift in the residual supply curve that serves as an instrument to estimate the average demand elasticity for the complementary group of investors that accommodate the demand shock.

Recent research has used novel identification strategies and extended the analysis of demand shocks beyond a small set of stocks that are affected by an index addition or deletion. Yen-Cheng Chang, Harrison Hong, and Inessa Liskovich use a regression discontinuity approach at the cutoff between Russell 1000 and 2000 indices. (2) Anna Pavlova and Taisiya Sikorskaya systematically extend this approach to all major stock indices. (3) Simon Schmickler exploits variation from institutional investors' predictable rebalancing across stocks due to dividend payouts. (4)

We use variation in investment mandates across institutional investors to estimate a demand system for the entire cross-section of US stocks. (5) The median demand elasticity across stocks in a given period averages to 0.4, but there is significant heterogeneity across stocks with elasticities up to 2. Our estimates, which agree with demand elasticities estimated by others, are three orders of magnitude smaller than those implied by calibrations of standard asset pricing models. For example, a calibration of the capital asset pricing model (CAPM) implies a demand elasticity for individual stocks that exceeds 5,000. (6) Investors should easily arbitrage any deviation from the CAPM because with limited idiosyncratic risk at the individual stock level, there is...