60 Pages Posted: 31 May 2016
Date Written: May 2016
Muir (2014) shows that the ratio of intermediary equity to GDP predicts future market returns and is a priced risk factor in the cross-section of stock returns. Here, I extend his work and show that expectations of large declines in the equity of financial institutions can also help explain equity returns. Specifically, I show that different measures of intermediary equity tail-risk are priced in the cross-section. Firms that load on this financial tail-risk factor have lower expected returns. Motivated by these facts, I develop an intermediary asset pricing model where the financial sector's net worth is subject to large negative shocks. I calibrate the model to U.S. data and find that stocks that do well when disaster risk is high earn significantly lower returns thus providing theoretical support to my findings. In addition, the model is able to match key asset pricing moments like the equity premium and the volatility of stock returns.
JEL Classification: E44, G01, G12, G20
Suggested Citation: Suggested Citation
Ayala, Andres, The Effect of Shocks to Intermediary Equity on Stock Returns (May 2016). Available at SSRN: https://ssrn.com/abstract=2786708