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Research Details

A Model of Capital and Crises, Review of Economic Studies

Abstract

We develop a model in which the capital of the intermediary sector plays a critical role in determining asset prices. The model is cast within a dynamic general equilibrium economy, and the role for intermediation is derived endogenously based on optimal contracting considerations. Low intermediary capital reduces the risk-bearing capacity of the marginal investor. We show how this force helps to explain patterns during ?nancial crises. The model replicates the observed rise during crises in Sharpe ratios, conditional volatility, correlation in price movements of assets held by the intermediary sector, and fall in riskless interest rates. In a dynamic context, we show that aversion to drops in intermediary capital can generate a two-factor asset pricing model with a role for both a market factor and a liquidity factor.

Type

Article

Author(s)

Zhiguo He, Arvind Krishnamurthy

Date Published

2012

Citations

He, Zhiguo, and Arvind Krishnamurthy. 2012. A Model of Capital and Crises. Review of Economic Studies. 79(2): 735-777.

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