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A Model of Capital and Crises

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  • Arvind Krishnamurthy

    (Northwestern Kellogg)

  • Zhiguo He

    (Chicago Booth)

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    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.

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    Bibliographic Info

    Paper provided by Society for Economic Dynamics in its series 2009 Meeting Papers with number 85.

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    Date of creation: 2009
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    Handle: RePEc:red:sed009:85

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    1. William K.H. Fung & David A. Hsieh, 2006. "Hedge funds: an industry in its adolescence," Economic Review, Federal Reserve Bank of Atlanta, issue Q 4, pages 1-34.
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    Cited by:
    1. Ang, Andrew & Gorovyy, Sergiy & van Inwegen, Gregory B., 2011. "Hedge fund leverage," Journal of Financial Economics, Elsevier, vol. 102(1), pages 102-126, October.

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