READING MATERIAL
DETERMINANTS OF ASSET DEMAND
Facing the question of whether to buy and hold an asset or whether to buy one asset rather
than another, an individual must consider the following factors:
1. Wealth, the total resources owned by the individual, including all assets
2. Expected return (the return expected over the next period) on one asset relative to
alternative assets
3. Risk (the degree of uncertainty associated with the return) on one asset relative to
alternative assets
4. Liquidity (the ease and speed with which an asset can be turned into cash) relative to
alternative assets
Wealth
When people find that their wealth has increased, they have more resources available with
which to purchase assets, and so, not surprisingly, the quantity of assets they demand increases.
The demand for different assets responds differently to changes in wealth, however; the quantity
demanded of some assets grows more rapidly with a rise in wealth than the quantity demanded of
others. The degree of this response is measured by a concept known as the wealth elasticity of
demand, which measures how much, with everything else unchanged, the quantity demanded of
an asset changes in percentage terms in response to a percentage change in wealth:
% change in quantity demanded / % change in wealth = wealth elasticity of demand
If, for example, the quantity of currency demanded increases only by 50 percent when wealth
increases by 100 percent, then currency has a wealth elasticity of demand of 1/2. If, for a common
stock, the quantity demanded increases by 200 percent when wealth increases by 100 percent, the
wealth elasticity of demand equals 2.
Assets can be sorted into two categories, depending on the value of their wealth elasticity of
demand. An asset is a necessity if there is only so much that people want to hold, so that as wealth
grows, the percentage increase in the quantity demanded of the asset is less than the percentage
increase in wealth – in other words, its wealth elasticity is less than 1. Because the quantity
demanded of a necessity does not grow proportionally with wealth, the amount of this asset that
people want to hold relative to their wealth falls as wealth grows. An asset is a luxury if its wealth
elasticity is greater than 1; and as wealth grows, the quantity demanded of this asset grows more
than proportionally, and the amount that people hold relative to their wealth grows.
The effect of changes in wealth on the quantity demanded of an asset can be summarized in
this way: Holding everything else constant, an increase in wealth raises the quantity demanded of
an asset, and the increase in the quantity demanded is greater if the asset is a luxury than if it is a
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necessity.
Expected Returns
The return on an asset measures how much investors gain from holding that asset. When
investors make a decision to buy an asset, they are influenced by what they expect the return on
that asset to be. If a Mobil Oil Corporation bond, for example, has a return of 15 percent half of
the time and 5 percent the other half of the time, its expected return is 10 percent. If the expected
return on the Mobil Oil bond rises relative to expected returns on alternative assets, holding
everything else constant, then it becomes more desirable to purchase it, and the quantity demanded
increases. This can occur in either of two ways: (1) when the expected return on the Mobil Oil
bond rises while the return on an alternative asset – say, stock in IBM – remains unchanged or (2)
when the return on the alternative asset, the IBM stock, falls while the return on the Mobil Oil
bond remains unchanged. To summarize, an increase in an asset’s expected return relative to that
of an alternative asset, holding everything else unchanged, raises the quantity demanded of the
asset.
Risk
The degree of risk or uncertainty of an asset’s returns also affects the demand for the asset.
Consider two assets, stock in Fly-by-Night Airlines and stock in Feet-on-the-Ground Bus
Company. Suppose that Fly-by-Night stock has a return of 15 percent half the time and 5 percent
the other half of the time, making its expected return 10 percent, while stock in
Feet-on-the-Ground has a fixed return of 10 percent. Fly-by-Night stock has uncertainty
associated with its returns and so has greater risk than stock in Feet-on-the-Ground, whose return
is a sure thing.
A risk-averse person prefers stock in Feet-on-the-Ground (the sure thing) to Fly-by-Night
stock (the riskier asset), even though the stocks have the same expected return, 10 percent. By
contrast, a person who prefers risk is a risk preferrer or risk lover. Most people are risk-averse:
Everything else being equal, they prefer to hold the less risky asset. Hence, holding everything
elso constant, if an asset’s risk rises relative to that of alternative assets, its quantity demanded
will fall.
Liquidity
Another factor that affects the demand for an asset is how quickly it can be converted into
cash without incurring large costs – its liquidity. An asset is liquid if the market in which it is
traded has depth and breadth, that is, if the market has many buyers and sellers. A house is not a
very liquid asset because it may be hard to find a buyer quickly; if a house must be sold to pay off
bills, it might have to be sold for a much lower price. A U.S. Treasury bill by contrast, is a highly
liquid asset; it can be sold quickly at low cost. The more liquid an asset is relative to alternative
assets, holding everything elso unchanged, the more desirable it is, and the greater will be the
quantity demanded.
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All the determining factors discussed above can be assembled into the theory of portfolio
choice, which states that, holding all of the other factors constant:
1. The quantity demanded of an asset is usually positively related to wealth, with the
response being greater if the asset is a luxury than if it is a necessity.
2. The quantity demanded of an asset is positively related to its expected return relative to
alternative assets.
3. The quantity demanded of an asset is negatively related to the risk of its returns relative
to alternative assets.
4. The quantity demanded of an asset is positively related to its liquidity relative to
alternative assets.
(Excerpted from Modern Investment Theory by Robert A.Haugen)
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