Financial Intermediaries and the Cross-Section of Asset Returns

Tyler Muir, Tobias Adrian, Erkko Etula
2011 Social Science Research Network  
Financial intermediaries trade frequently in many markets using sophisticated models. Their marginal value of wealth should therefore provide a more informative stochastic discount factor (SDF) than that of a representative consumer. Guided by theory, we use shocks to the leverage of securities broker-dealers to construct an intermediary SDF. Intuitively, deteriorating funding conditions are associated with deleveraging and high marginal value of wealth. Our single-factor model prices size,
more » ... el prices size, book-to-market, momentum, and bond portfolios with an R 2 of 77% and an average annual pricing error of 1%-performing as well as standard multifactor benchmarks designed to price these assets. 2557 1 See Jagannathan and Wang (2007) for evidence that households may optimize infrequently and Malloy, Moskowitz, and Vissing-Jorgensen (2009) for evidence that limited participation in the stock market can help explain the cross-section of stock returns and the equity premium puzzle. 2 An insight due to He and Krishnamurthy (2013) . 3 The returns on momentum portfolios have thus far been particularly difficult to connect to risk. We regard the strong pricing performance across transaction-cost-intensive momentum and bond portfolios as an indication that these portfolios are better priced by the SDF of a sophisticated intermediary.
doi:10.2139/ssrn.1786061 fatcat:ykzclfaevngzfmsriofkyrqtny