N°22-67: On the Estimation of Demand-Based Asset Pricing Models

A growing literature uses portfolio holdings data to quantify the impact of investor demand on equilibrium prices via counterfactual experiments. The key parameter in relating demand and equilibrium prices is investors’ elasticity of demand with respect to the price. Unlike previous studies, which rely on cross-sectional estimates in levels, this paper proposes estimating elasticities from investors’ trades, that is changes in their portfolios. I use demand shocks from mutual fund flows as an instrument to address the endogeneity of trades and prices. Using the estimation in changes along with the flow-based instrument I find that elasticities are 4 times larger than what previous estimates suggest. Estimation over different trading horizons furthermore shows that investors become more elastic in the long run. The results suggest that the impact of demand shocks on equilibrium prices is smaller than previously estimated and partly reverts over time.