Asset Pricing with a Financial Sector
65 Pages Posted: 16 Feb 2013 Last revised: 12 Oct 2013
Date Written: October 10, 2013
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: Suggested Citation