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The cost of capital in markets with opaque intermediaries and the risk-structure of interest rates

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  • Mierzejewski, Fernando

Abstract

The demand for cash balances of financial intermediaries that establish contractual liabilities with credit-sensitive customers is characterised. As stated by Merton, the success of the business activities of such firms crucially depends on their credit quality, and hence, they are obliged to rely on deposit insurance and capital cushions in order to assure that their promised payments are free of default. Unlike the Merton’s approach, the optimal guaranteeing contract is formulated in actuarial terms in this paper, because in this way the model can be extended to consider the situation of firms that can only hedge up to a limited extent. Within this framework, the equilibrium in the market determines the rate at which a unit of capital is exchange by a unit of risk, or, in other words, it determines the market price of risk. Episodes of liquidity crises are meaningful in this theoretical setting.

Suggested Citation

  • Mierzejewski, Fernando, 2008. "The cost of capital in markets with opaque intermediaries and the risk-structure of interest rates," MPRA Paper 9827, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:9827
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    File URL: https://mpra.ub.uni-muenchen.de/14942/2/MPRA_paper_14942.pdf
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    References listed on IDEAS

    as
    1. Holmstrom, Bengt & Tirole, Jean, 2000. "Liquidity and Risk Management," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 295-319, August.
    2. William F. Sharpe, 1965. "Mutual Fund Performance," The Journal of Business, University of Chicago Press, vol. 39, pages 119-119.
    3. Milton Friedman, 1971. "A Theoretical Framework for Monetary Analysis," NBER Books, National Bureau of Economic Research, Inc, number frie71-1.
    4. J. Tobin, 1958. "Liquidity Preference as Behavior Towards Risk," Review of Economic Studies, Oxford University Press, vol. 25(2), pages 65-86.
    5. Jensen, Michael C, 1986. "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review, American Economic Association, vol. 76(2), pages 323-329, May.
    6. Robert C. Merton & André Perold, 1993. "Theory Of Risk Capital In Financial Firms," Journal of Applied Corporate Finance, Morgan Stanley, vol. 6(3), pages 16-32.
    7. Choi, Woon Gyu & Oh, Seonghwan, 2003. " A Money Demand Function with Output Uncertainty, Monetary Uncertainty, and Financial Innovations," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(5), pages 685-709, October.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    The cost of capital; Liquidity preference; Monetary equilibrium; Financial instability; Liquidity crises;

    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E41 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Demand for Money

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