Asset Pricing with a Financial Sector

65 Pages Posted: 16 Feb 2013 Last revised: 12 Oct 2013

See all articles by Kai Li

Kai Li

Peking University HSBC Business School

Date Written: October 10, 2013

Abstract

This paper studies the quantitative asset pricing implications of financial intermediary which faces an endogenous leverage constraint. I use a recursive method to construct the global solution that accounts for occasionally binding constraint. Quantitatively, the model generates a high and countercyclical equity premium, a low and smooth risk-free interest rate, and a procyclical and persistent variation of price-dividend ratio, despite an independently and identically distributed consumption growth process and a moderate risk aversion of 10. As a distinct prediction from the model, when the intermediary is financially constrained, interest rate spread between interbank and household loans spikes. This pattern is consistent with the empirical evidence that high TED spread coincides with low stock price and high stock market volatility, which I confirm in the data.

Keywords: Financial Intermediary, Equity Premium, Return Predictability, TED spread, Global Method

JEL Classification: G12, G2, E44

Suggested Citation

Li, Kai, Asset Pricing with a Financial Sector (October 10, 2013). Asian Finance Association (AsFA) 2013 Conference, Available at SSRN: https://ssrn.com/abstract=2219200 or http://dx.doi.org/10.2139/ssrn.2219200

Kai Li (Contact Author)

Peking University HSBC Business School ( email )

+86 755 26032023 (Phone)

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