Asset pricing with index investing

Georgy Chabakauri and Oleg Rytchkov

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: We provide a novel theoretical analysis of how index investing affects capital market equilibrium. We consider a dynamic exchange economy with heterogeneous investors and two Lucas trees and find that indexing can either increase or decrease the correlation between stock returns and in general increases (decreases) volatilities and betas of stocks with larger (smaller) market capitalizations. Indexing also decreases market volatility and interest rates, although those effects are weak. The impact of index investing is particularly strong when stocks have heterogeneous fundamentals. Our results highlight that indexing changes not only how investors can trade but also their incentives to trade.

Keywords: asset pricing; indexing; heterogeneous investors; Lucas trees (search for similar items in EconPapers)
JEL-codes: D52 G12 (search for similar items in EconPapers)
Pages: 45 pages
Date: 2014-11
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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:60739

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