A Supply and Demand Based Price Model for Financial Assets

Abstract

This paper proposes a price model for financial assets using the supply-demand relationship, referred to as a supply and demand based price (SDP) model for financial assets. The model demonstrates that stock price volatility is characterized by the downward sloping demand curve and volume fluctuation, not by another stochastic volatility process often employed in security markets. In particular, it is found that the flatter demand curve using inverse Box-Cox transformation with a positive parameter causes the asymmetric volatility, i.e., negative price return-volatility correlation, often observed in security markets. The model can also classify the asymmetric volatility into leverage effect and feedback effect examining the relationship between expected price return and volatility. We then characterize the time varying market price of risk based on the SDP model. Empirical studies using a recent decade data for many asset classes show that stock market indices, freight indices, and carbon assets possess positive inverse Box-Cox transformation parameters, resulting in asymmetric volatility while commodity-related assets tend to have negative parameters, resulting in inverse leverage effects. In contrast, using the long run data from 1950 to 2009, we illustrate the inverse leverage effect in security markets. Finally, we show that the positive risk and return relationship holds if the expected return is positive, regardless of the asset class.