Option-Based Intermediary Leverage
Posted: 19 Nov 2020 Last revised: 14 Sep 2022
Date Written: September 11, 2022
We introduce a new proxy for the health of financial intermediaries-the Leverage Bearing Capacity (LBC). LBC is the leverage of a fictitious intermediary that targets a fixed level of risk and rebalances its capital structure on an ongoing basis. Our measure is based on market values, incorporates off-balance sheet activities, is available at any frequency, and inherently captures higher-order risks. We analyze the dynamics of LBC in event studies and demonstrate that it is closely linked to financial sector uncertainty. Building on an intermediary asset pricing model, we validate that LBC proxies the marginal wealth of intermediaries. Empirically, it explains the expected returns across several asset classes and subsumes the explanatory power of existing measures of intermediaries’ health, financial uncertainty, higher-order risks, and common risk factors.
Keywords: Intermediary asset pricing, financial intermediation, option-implied information, leverage, financial constraints, risk-bearing capacity, balance sheet valuation
JEL Classification: G12, G13, G20, G32
Suggested Citation: Suggested Citation