Essays on index premia and demand curves for stocks

This thesis consists of three chapters that investigate the index premium and its underlying economics both theoretically and empirically. The first chapter presents our empirical findings about the index premium and its properties. First, we find that the index premia for both the S&P 500 and Russell 2000 have been growing over time, reaching levels of about 15% and 10%, respectively, in 2000. The premia arise somewhat gradually between the announcement and effective days and do not reverse at least in the next few weeks. Second, we find that the index premium is related to the idiosyncratic risk and market equity of a firm with economic and statistical significance. Third, we introduce a new concept that we label the index turnover cost, which represents a cost borne by index funds due to the index premium. We illustrate this cost and estimate it as 70-85 bp annually for the S&P 500 and 110-211 bp annually for the Russell 2000. The second chapter develops the first theoretical explanation in the literature for downward-sloping demand curves. In traditional multi-asset models such as the CAPM, demand curves for stocks are almost perfectly horizontal, because a representative investor who is sufficiently risk-tolerant to hold the entire market portfolio has to be almost indifferent to idiosyncratic risk. We start with the basic CAPM setting, but we further assume that there is a fixed cost to actively managing a stock portfolio and that individuals pay the cost through an institution as a proportional fee. In equilibrium, the proportional fee can entirely determine the cross-sectional pricing of stocks, while the risk aversion of individual investors still determines the aggregate market risk premium.

Department dc:contributor.department

Sloan School of Management.

Grantor dc:publisher

Massachusetts Institute of Technology

Year dc:date.issued

2003

Author dc:creator

• Petäjistö, Antti, 1974-

Advisor dc:contributor.advisor

• Stephen A. Ross and Jiang Wang.

• Sloan School of Management.

Statement dc:rights

• M.I.T. theses are protected by copyright. They may be viewed from this source for any purpose, but reproduction or distribution in any format is prohibited without written permission. See provided URL for inquiries about permission.

Licence dc:rights.uri

• http://dspace.mit.edu/handle/1721.1/7582

Language dc:language.iso

eng

Handle dc:identifier.uri

http://hdl.handle.net/1721.1/17601

OAI identifier oai:identifier

oai:dspace.mit.edu:1721.1/17601