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| Type | Master's Thesis |
| Scope | Discipline-based scholarship |
| Title | Applying the inelastic market hypothesis to active and passive managed funds and predicting price movements |
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| Institution | University of Zurich |
| Faculty | Faculty of Business, Economics and Informatics |
| Number of Pages | 68 |
| Date | 2022 |
| Abstract Text | In this thesis I investigate the inelastic market hypothesis by Gabaix and Koijen (2021), henceforth G&K. They hypothesize that, due to constrained market participants, price elasticity of demand of stock prices is smaller than commonly assumed. The consequence is that inflow and outflow in and out of the stock market have a massive price impact. Mainstream models assume asset demand to be highly elastic. In this case small changes in prices lead to a large change in demand but changes in demand would not change price by much. In those models the price is the direct result of discounted future cash flows or dividends. Market movement would only impact the prices in a small way and only short term. Arbitrageurs would instantly profit from these mispricings and thus rebalance the market. G&K propose a fundamentally di↵erent approach. They argue that the market is inelastic. The main driving force behind this are the constraints laid upon a large share of market participants. Those institution are subject to a multitude of regulations, most importantly their fixed equity share. This mandate on equity share creates additional market forces that result in this extreme price reaction. G&K make the key distinction between micro and macroeconomic elasticity. They specifically focus on the macroeconomic price elasticity that concerns the inflow of money into the stock market from outside the stock market. This is in contrast to microeconomic elasticity that is concerned with the price elasticity stemming from movements within the stock market. They find the price impact multiplier M to be around 5. This implies that a 1$ inflow into the stock market increases the aggregated value of the stock market by around 5$. This result is remarkable and would have severe impact into the fundamentals of asset pricing and the whole financial sector. It would help explain the pseudo-random behaviour of asset prices. It would also allow governments to adapt their quantitative easing approach and influence the markets more directly through stock purchase rather than through bonds. I critically discuss all the theoretical reasons given by G&K and combine it with existing literature on this topic. I especially focus on non-linear and asymmetric extensions as well as the micro foundation of these market forces. In my empirical part I use proprietary Swiss and US mutual funds data provided by Morningstar. |
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