Levered Ideas: Risk Premia along the Credit Cycle

Lukas Schmid and Wenxi Liao
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Lukas Schmid: Duke University
Wenxi Liao: Fuqua School of Business

No 1500, 2017 Meeting Papers from Society for Economic Dynamics

Abstract: We quantitatively evaluate a general equilibrium model in which the endogenous supply of collateral drives the joint dynamics of credit, risk and risk premia. Endogenous adoption facilitates the transformation of intangible ideas into technology that productive firms can borrow against. In the model, the arrival of new technologies drives the ratio between ideas and collateralizable capital (IC ratio) which is a significant predictor of leverage and returns in stock and corporate bond markets. In particular, a high IC ratio predicts a high market price of risk and high unlevered returns to technology adoption, while a low IC ratio comes with a low market price of risk but high levered returns. Interpreted in the context of venture capitalists (adopters) and buyout funds (levered firms), the model rationalizes repeated, but distinct, venture capital and buyout waves, and returns. Quantitatively, our model of a credit cycle driven by the slow transformation of new ideas into collateralizable assets rationalizes well the predictability evidence in stock and corporate bond markets.

Date: 2017
New Economics Papers: this item is included in nep-dge
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