Journal Article

A Model of Capital and Crises

Zhigu He and Arvind Krishnamurthy

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 79, issue 2, pages 735-777
Published in print April 2012 | ISSN: 0034-6527
Published online September 2011 | e-ISSN: 1467-937X | DOI: http://dx.doi.org/10.1093/restud/rdr036
A Model of Capital and Crises

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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.

Keywords: Liquidity; Hedge funds; Delegation; Financial institutions; G12; G20; E44

Journal Article.  17645 words.  Illustrated.

Subjects: Financial Institutions and Services ; Economics ; Money and Interest Rates

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