1. Institutional Investor Behavior in X-CAPM
Erdem Kilic, Associate Professor;
MEF University
Abstract
Methods
This study aims to model institutional investor behavior in the XCAPM model under the premise of reflecting a more detailed decomposition of investor types in equity markets. We explore the behavior and its impact in the model, esp. on pricing and on key financial ratios. We observe that the prevalence of the institutional investor counteracts extrapolator’s effects, resulting in lower volatility of price dividend ratio, lower predictive power of changes in consumption for future price changes and lower equity premium.
The basic framework is a consumption-based model of asset prices and returns, where extrapolative expectations are incorporated.
Prices expressed in stochastic form of sentiment level.
Constant absolute risk aversion preferences (CARA).
Optimal consumption-portfolio decision applied by help of stochastic dynamic programming under budget constraint composed of wealth, consumption and investment in risky assets.
Based on optimization solution, market equilibrium is determined. Equilibrium values are determined for model parameters related to optimal consumption policies, price levels, dividends and volatility of prices for each market decomposition structure.
Model predicitions for ratio-based quantities are determined (See Table 2).
Introduction
In the XCAPM model Barberis et al. (2015) describe an intertemporal consumption asset pricing model, where prices are driven by sentiment dynamics. Two investor types are considered in their proposed model, namely, rational and extrapolator investor. To acknowledge for an agent in-between these fundamentally different two types of investors, we introduce a new investor type into the model, who has more behavioral attributes which are related closer to the rational investor. This study therefore aims to explore the institutional investor behavior and impact in the model and on pricing.
Discussion
Incorporating the institutional investor into the original XCAPM model, we observe several modified results, concerning the model implications.
The predictive power of dividend price ratio increases at longer horizons. We see that D/r-P is low in rational and institutional dominated markets.
Autocorrelation of P – D/r ratio drops to 0 at longer horizon, when rational and institutional investor types dominate the market. Contrary, it is persistent even at longer horizon in extrapolator dominated markets.
Volatility of price changes decreases, when institutional investor fraction increases. Thus, the amplifying effects from extrapolators are dampened by institutionals.
When there is low persistence in extrapolator's beliefs, the autocorrelation of price changes have more negative values under extrapolator domination. Under institutional domination autocorrelation is close to 0 with negative values.
In general, lower correlation between consumption and price changes can be observed if extrapolators put more weight on current price changes and vice versa. For extrapolator dominated markets correlation decreases, for rational dominated markets correlation increases. The correlation in institutional dominated markets are lower than for rational dominated markets.
In extrapolator dominated markets, negative values can be observed for the predictive power of changes in consumption for future price changes, when extrapolators put more weight on current price changes. For institutional domination, the value is almost zero or very close to zero, however, negative for rational domination, and most negative for extrapolator dominated markets. Lower correlation is observed if extrapolators put more weight on current price changes.
Overvaluation in prices is slightly dampened in institutional dominated markets, which is observable in more stabilized outcomes and presumably in contrarian behavior.
Equity premium for extrapolator dominated markets are higher than for institutional and rational dominated markets, esp. when extrapolators put more weight on current price changes. For institutional dominated markets equity premium are higher than for rational dominated markets.
Table 1. Investor Types
Extrapolator
Institutional
Rational
expected price change is a weighted exponential average of past price changes, where more recent price changes are weighted more heavily
incorporate extrapolators beliefs in expectations, not fully rational, uncertainty in price movements
Fully rational, knows extrapolator’s beliefs
Table 2. Model Implications
Financial Ratios
Time Horizon
High fraction of Extrapolators
High fraction of Rationals and Institutionals
Predictive Power of D/r – P for future price changes
Increases at longer horizons
High
Low, for high persistence in extrapolators beliefs even lower
Autocorrelation of price dividend ratio (P - D/r)
At longer horizons drop to zero, not for extrapolators dominated markets
Highly persistent at short time horizon, near zero at longer horizon
Increasing
for higher persistence in extrapolator beliefs even higher
Volatility of price dividend ratio (P - D/r)
No time dimension
Higher
Lower, institutionalists dampen volatility
Autocorrelation of price changes
All time horizons
near to zero
Weight on recent price changes = 0.05
Similar
Weight = 0.5
Higher and positive
Lower and negative
Weight = 0.75
Negative close to zero
Positive close to zero
Correlation of consumption, price changes and P-D/r
Lower correlation between C and P changes for higher betas
Correlation increases
Higher betas lower correlation
Predictive Power of changes in consumption for future price changes
Higher values in absolute terms for increasing time horizon
Negative, esp. for high betas, less persistent extrapolator beliefs
Zero for rational and institutional dominated markets
Equity premium
Lower
Conclusions
This study reveals the role of an institutional investor in the XCAPM model. We find that institutional investors, to some extent, can counteract the extrapolator’s effects. This can be seen in certain model implications, such as, lower volatility in price dividend ratio and price changes. Overvaluation in prices are slightly dampened in institutional dominated markets, which is observable in more stabilized outcomes, that presumably results from their contrarian behavior. Compared to the original model, it is observable that extrapolator’s effects are not fully offset by inclusion of the institutional investor.
Contact
References
Erdem Kilic
MEF University
Website:
Phone:
Barberis, Nicholas, Robin Greenwood, Lawrence Jin, and Andrei Shleifer. "X-CAPM: An extrapolative capital asset pricing model." Journal of financial economics 115, no. 1 (2015): 1-24.
Son-Turan, Semen, and Erdem Kilic. "X-Capm Revisited: The Institutional Extrapolative Capital Asset Pricing Model (IX-Capm)." Eurasian Journal of Business and Management 6, no. 3 (2018): 1-9.