A Model of Capital and Crises

52 Pages Posted: 2 Oct 2008 Last revised: 28 Jul 2010

Multiple version iconThere are 2 versions of this paper

Date Written: September 2008

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.

Suggested Citation

He, Zhiguo and Krishnamurthy, Arvind, A Model of Capital and Crises (September 2008). NBER Working Paper No. w14366. Available at SSRN: https://ssrn.com/abstract=1276626

Zhiguo He (Contact Author)

University of Chicago - Finance ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

HOME PAGE: http://www.zhiguohe.com

Arvind Krishnamurthy

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States
847-491-2671 (Phone)
847-491-5719 (Fax)

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