Demand Elasticity in Dynamic Asset Pricing (Zhiguo He, Peter Kondor and Jessica Li) 

Abstract

We show that the standard econometric approach relying on exogenous residual supply shocks systematically underestimates the slope of investors' asset demand curves in dynamic settings. We develop a multi-asset, multi-agent continuous-time model featuring long-lived investors and short-lived hedgers whose demand shifts create exogenous supply changes. Our key finding is that these supply shifts alter the very demand slope that econometricians seek to measure through general equilibrium effects. Namely, supply shifts affect endogenous risk (return volatility and covariance) and change the comovement of returns with future investment opportunities. We compare the ``observed slope" measured by econometricians against the true ``dynamic slope" derived from investors' first-order condition. Using calibrations based on mutual fund demand shifts and index inclusion events, we find that the dynamic slope is two to seven times larger than the observed measures. The effect through endogenous risk dominates this mismeasurement, while the magnitude depends critically on shock persistence, size, and investor risk aversion.