Asset Pricing and the Credit Market

37 Pages Posted: 7 May 2008

See all articles by Francis A. Longstaff

Francis A. Longstaff

University of California, Los Angeles (UCLA) - Finance Area; National Bureau of Economic Research (NBER)

Jiang Wang

Massachusetts Institute of Technology (MIT) - Sloan School of Management; China Academy of Financial Research (CAFR); National Bureau of Economic Research (NBER)

Date Written: April 2008

Abstract

We study asset pricing and trading behavior in an exchange economy populated by two agents with different risk aversion. We show that the credit market plays a central role in the risk sharing between the two agents. It allows the less-risk-averse agent to borrow in order to take on levered positions in the stock and thus bear more risk. Optimal risk sharing results in the more-risk-averse agent effectively selling covered call" options to the less-risk-averse agent. As the state of the economy changes, the equilibrium amount of credit in the market also fluctuates, which in turn influences expected stock returns, stock return volatility, the term structure of interest rates, and trading activity in the stock market. We further explore the immediate empirical implication that variation in the size of the credit market is related to variation in expected stock returns. Using various measures of changes in the size of the credit market, we find that they have significant power in forecasting one-year excess returns of the stock market. Our results suggests that the credit sector is of fundamental importance to the behavior of asset prices.

Keywords: Asset pricing, Credit market, Leverage

JEL Classification: E43, E44, G11, G12

Suggested Citation

Longstaff, Francis A. and Wang, Jiang, Asset Pricing and the Credit Market (April 2008). Available at SSRN: https://ssrn.com/abstract=1129304 or http://dx.doi.org/10.2139/ssrn.1129304

Francis A. Longstaff (Contact Author)

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-2218 (Phone)
310-206-5455 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Jiang Wang

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

E62-614
100 Main Street
Cambridge, MA 02142
United States
617-253-2632 (Phone)
617-258-6855 (Fax)

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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