A Model of Capital and Crises

Arvind Krishnamurthy and Zhiguo He ()

No 85, 2009 Meeting Papers from Society for Economic Dynamics

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.

Date: 2009
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Related works:
Journal Article: A Model of Capital and Crises (2012)
Working Paper: A Model of Capital and Crises (2008)
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed009:85

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