A Model of Capital and Crises

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 financial 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.

Number of Pages in PDF File: 49

Keywords: Liquidity, Hedge Funds, Delegation, Financial Institutions

JEL Classification: G12, G2, E44

working papers series