Intermediary Asset Pricing

Abstract

We model the dynamics of risk premia during crises in asset markets where the marginal investor is a financial intermediary. Intermediaries face an equity capital constraint. Risk premia rise when the constraint binds, reflecting the capital scarcity. The calibrated model matches the nonlinearity of risk premia during crises, and the speed of reversion in risk premia from a crisis back to pre-crisis levels. We evaluate the effect of three government policies: reducing intermediaries borrowing costs, injecting equity capital, and purchasing distressed assets. Injecting equity capital is particularly effective because it alleviates the equity capital constraint that drives the model's crisis.

Keywords: Liquidity, LTCM Crisis, Subprime Crisis, Delegated Portfolio Management, Financial Institutions, Asset Pricing, Collateral, Credit

JEL Classification: G12, G2, E44