Dynamic asset pricing in delegated investment: An investigation from the perspective of heterogeneous beliefs of institutional and retail investors

Abstract

What impact does delegated investment have on the price and volatility of the stock market? Traditional theoretical models believe that under benchmark-based incentives, institutional investment will push up stock prices and increase market volatility. This article extends traditional dynamic equilibrium models by incorporating investors' heterogeneous beliefs. In a continuous-time framework, we derive closed-form solutions to investors' dynamic portfolio strategies as well as the risky asset's equilibrium price and volatility. Numerical results show that heterogeneity in investors' beliefs can mitigate the risk of asset price bubbles, but renders the risky asset price more sensitive to cashflow news, increasing its volatility. While the convex incentive to institutional investors always boosts the risky asset price, it may increase or decrease risky asset volatility depending on whether institutional investors are more optimistic than retail investors. These theoretical results provide a new perspective from which to explain empirical findings and design future empirical studies.