A Model of Capital and Crises

49 Pages Posted: 15 Mar 2009 Last revised: 19 Sep 2010

Multiple version iconThere are 2 versions of this paper

Date Written: September 15, 2010


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.

Keywords: Liquidity, Hedge Funds, Delegation, Financial Institutions

JEL Classification: G12, G2, E44

Suggested Citation

He, Zhiguo and Krishnamurthy, Arvind, A Model of Capital and Crises (September 15, 2010). AFA 2011 Denver Meetings Paper, Available at SSRN: https://ssrn.com/abstract=1359451 or http://dx.doi.org/10.2139/ssrn.1359451

Zhiguo He (Contact Author)

Stanford University - Knight Management Center ( email )

655 Knight Way
Stanford, CA 94305-7298
United States

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)