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Title: Asset Prices and Institutional Investors

Author(s): Suleyman Basak and Anna Pavlova

Publication Date: September 2012

Keyword(s): asset class, Asset pricing, general equilibrium, indexing, institutions and money management

Programme Area(s): Financial Economics

Abstract: Empirical evidence indicates that trades by institutional investors have sizable effects on asset prices, generating 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 to 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 benchmark 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 aggregate stock market volatility, and give rise to countercyclical Sharpe ratios. Trades by institutions induce excess correlations among stocks that belong to their benchmark index, generating an asset-class effect.

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Bibliographic Reference

Basak, S and Pavlova, A. 2012. 'Asset Prices and Institutional Investors'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=9120