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A Model of Capital and Crises

Author

Listed:
  • Arvind Krishnamurthy

    (Northwestern Kellogg)

  • Zhiguo He

    (Chicago Booth)

Abstract

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.

Suggested Citation

  • Arvind Krishnamurthy & Zhiguo He, 2009. "A Model of Capital and Crises," 2009 Meeting Papers 85, Society for Economic Dynamics.
    • Handle: RePEc:red:sed009:85
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    More about this item

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G2 - Financial Economics - - Financial Institutions and Services

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