Asset Prices and Institutional Investors

  • Basak S
  • Pavlova A
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Abstract

Empirical evidence indicates that trades by institutions have sizable effects on asset prices, gener- ating phenomena such as index effects, asset class effects and others. It is difficult to explain such phenomena within standard representative-agent asset pricing models. In this paper, we consider an economy populated by institutional investors alongside standard retail investors. Institutions care about their performance relative a certain index. Our framework is tractable, admitting exact closed-form expressions, and produces the following analytical results. We find that institutions optimally tilt their portfolios towards stocks that comprise their index. The resulting price pressure boosts index stocks, while leaving nonindex stocks unaffected. By demanding a higher fraction of risky stocks than retail investors, institutions amplify the index stock volatilities and the aggregate stock market volatility. Trades by institutions induce excess correlations among stocks that belong to their index, generating an asset class effect. Institutions finance their additional purchases of index stocks by taking on leverage. A policy prescription that calls for a reduction in leverage, while reducing the riskiness of institutional portfolios, would also reduce the ability of institutions to tilt their portfolios towards index stocks, depressing the index level.

Author-supplied keywords

  • asset pricing
  • general equilibrium
  • indexing
  • institutions
  • money management

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Authors

  • Suleyman Basak

  • Anna Pavlova

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