Why Do Demand Curves for Stocks Slope Down?
October 2009 (published version) (working paper) Journal of Financial and Quantitative Analysis, 2009, 44(5):1013-1044 (lead article) An earlier and more comprehensive version, including results on endogeneously arising institutions and optimal institutional structure (pdf file) Separate appendices: Empirical tests (pdf file) and a more elaborate model (pdf file) Representative agent models are inconsistent with existing empirical evidence for steep demand curves for individual stocks. This paper resolves the puzzle by proposing that stock prices are instead set by two separate classes of investors. While the market portfolio is still priced by individual investors based on their collective risk aversion, those individual investors also delegate part of their wealth to active money managers who use that capital to price stocks in the cross-section. In equilibrium the fee charged by active managers has to equal the before-fee alpha they earn; this endogenously determines the amount of a
