Asset Pricing with a Financial Sector

Abstract

In this paper, we study the quantitative asset pricing implications of a financial intermediary
that faces a leverage constraint. We use a recursive method to construct the global solution that accounts for occasionally binding constraints. Quantitatively, our model generates a high and countercyclical equity premium, a low and smooth risk-free interest rate, and a procyclical and persistent price-dividend ratio, despite an independently and identically distributed consumption growth process and a moderate risk aversion of 10. As a distinct prediction from our model, we find that when the intermediary is financially constrained, the interest rate spread between interbank and household loans spikes. This pattern is consistent with the empirical evidence that high TED spread coincides with low stock price and high stock market volatility.

Keywords: Financial Intermediary, Equity Premium, Return Predictability, TED spread, Global Method

JEL Classification: G12, G2, E44