Asset pricing with index investing

Georgy Chabakauri and Oleg Rytchkov

Journal of Financial Economics, 2021, vol. 141, issue 1, 195-216

Abstract: We theoretically analyze how index investing affects financial markets using a dynamic exchange economy with heterogeneous investors and two Lucas trees. We identify two effects of indexing: lockstep trading of stocks increases market volatility and stock return correlations but reduction in risk sharing decreases them. Overall, indexing decreases market volatility but has an ambiguous effect on the correlations. Also, index investing decreases an investor’s welfare, but indexing by other investors partially offsets the loss. When the introduction of index trading opens financial markets for new investors, the improved risk sharing makes market returns more volatile and stock returns more correlated.

Keywords: Indexing; Risk sharing; Lucas trees; General equilibrium; Heterogeneous investors (search for similar items in EconPapers)
JEL-codes: D52 D53 G12 (search for similar items in EconPapers)
Date: 2021
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:141:y:2021:i:1:p:195-216

DOI: 10.1016/j.jfineco.2020.06.023

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