[Research Seminar 2019.10.16] Heterogeneous Intermediary Capital, Asset Prices, and Fire Sales

Abstract

This paper examines how heterogeneity in intermediary capital – the equity capital ratio of the largest financial intermediaries in the U.S. – affects the cross-section of stock returns. We estimate the exposure (i.e., beta) of individual stocks to a shock in the dispersion of intermediary capital and find that stocks in the lowest beta decile generate an additional 6.8% – 8.2% annual return relative to stocks in the highest beta decile. Using data from Institutional (13F) Holdings, we also find evidence that low-capital intermediaries, who hold riskier assets than high-capital intermediaries, face leverage-induced fire sales during bad times. We propose a model of heterogeneous intermediary capital in which heterogeneous risk preference between high- and low-capital intermediaries leads to a countercyclical variation in aggregate risk aversion and a risk premium. The model states that the dispersion of intermediary capital is priced in the cross-section of asset prices, which supports the empirical findings.