Equilibrium Asset Pricing in Directed Networks
Review of Finance, Volume 25, Issue 3, May 2021, 777–818.
Posted: 11 Nov 2014 Last revised: 24 Jun 2021
Date Written: July 30, 2020
Directed links in cash flow networks affect the cross-section of risk premia through three channels. In a tractable consumption-based equilibrium asset pricing model, we obtain closed-form solutions that disentangle these channels for arbitrary directed networks. First, shocks that can propagate through the economy command a higher market price of risk. Second, shock-receiving assets earn an extra premium since their valuation ratios drop upon shocks in connected assets. Third, a hedge effect pushes risk premia down: when a shock propagates through the economy, an asset that is unconnected becomes relatively more attractive and its valuation ratio increases.
Keywords: Directed cash flow networks, directed shocks, mutually exciting processes, recursive preferences
JEL Classification: G12, D85
Suggested Citation: Suggested Citation