We develop a model in which the capital of the intermediary sector plays a critical role in determining asset prices. The model is cast within a dynamic general equilibrium economy, and the role for intermediation is derived endogenously based on optimal contracting considerations. Low intermediary capital reduces the risk-bearing capacity of the marginal investor. We show how this force helps to explain patterns during financial crises. The model replicates the observed rise during crises in Sharpe ratios, conditional volatility, correlation in price movements of assets held by the intermediary sector, and fall in riskless interest rates. In a dynamic context, we show that aversion to drops in intermediary capital can generate a two-factor asset pricing model with a role for both a market factor and a liquidity factor.
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Length: Date of creation: Sep 2008 Date of revision: Handle: RePEc:nbr:nberwo:14366
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Find related papers by JEL classification: E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy G12 - Financial Economics - - General Financial Markets - - - Asset Pricing G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation G2 - Financial Economics - - Financial Institutions and Services
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