Working Paper: NBER ID: w14517
Authors: Zhiguo He; Arvind Krishnamurthy
Abstract: We present a model to study the dynamics of risk premia during crises in asset markets where the marginal investor is a financial intermediary. Intermediaries face a constraint on raising equity capital. When the constraint binds, so that intermediaries' equity capital is scarce, risk premia rise to reflect the capital scarcity. We calibrate the model and show that it does well in matching two aspects of crises: the nonlinearity of risk premia during crisis episodes; and, the speed of adjustment in risk premia from a cri- sis back to pre-crisis levels. We use the model to quantitatively evaluate the effectiveness of a variety of central bank policies, including reducing intermediaries' borrowing costs, infusing equity capital, and directly intervening in distressed asset markets. All of these policies are effective in aiding the recovery from a crisis. Infusing equity capital into intermediaries is particularly effective because it attacks the equity capital constraint that is at the root of the crisis in our model.
Keywords: Asset Pricing; Financial Intermediaries; Risk Premia; Central Bank Policies
JEL Codes: G01; G2; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Scarcity of equity capital (O16) | Higher risk premia (G19) |
| Low intermediary capital (E22) | Significant effects on risk premia (G41) |
| High intermediary capital (E22) | Negligible effects from losses (G33) |
| Central bank policies (E58) | Aid in crisis recovery (H84) |
| Equity infusion (O16) | Addresses root capital constraint (O16) |