A Quantity Approach to Market Volatility
Title: A Quantity Approach to Market Volatility
Abstract: I show that the interaction between active and passive investment styles in financial markets is a strong determinant of the predictability of returns and volatility. These effects are explained by a general equilibrium model where optimizing agents respond to earnings and to participants whose asset allocation mandate is not related to fundamental news. The effect of passive flows is larger when active investors avoid risky bets, inducing time variation in the distribution of returns conditional on the information available in efficient markets. The closed-form solutions of the model explicitly recognize the composition of investment flows and are empirically estimated using daily stock market and quarterly holdings data. I find empirical support for numerous predictions of the model.