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

Abstract

The demand-system approach identifies asset demand slopes using residual supply shocks, presuming these shocks move expected returns but not risk. In dynamic economies, risk is endogenous: investors retrade, so demand depends on the joint distribution of current and future returns, which changes as investors absorb a shock. The shock therefore changes the demand curve it traces, violating the exclusion restriction. In a calibrated multi-asset dynamic model, the measured slope is roughly 40% of its conceptual counterpart, implying substantially steeper demand curves than standard estimates suggest. The bias persists even if shocks are infinitesimal and transitory. We discuss potential empirical remedies.