Mandate Models and the Inelastic Market Hypothesis

ABSTRACT

The aggregate equity market displays only small price elasticity; in particular, macroeconomic allocations in and out of the equity market lead to surprisingly large impacts on stock valuations. Gabaix and Koijen study this phenomenon and provide a theoretical framework to explain the observed price inelasticity. They consider financial agents who are constrained in their investment strategies and subjected to a mandate that prescribes their investment allocations. Here we develop a rigorous framework of a mandate model for a representative agent and provide precise conditions under which the stock valuation dynamics are well defined. We also study how mandates amplify or attenuate the response of stock capitalization to changes in bond capitalization. We furthermore formulate conditions under which different funds, each one equipped with their own mandate, can be aggregated to a representative fund.