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A Unifying Theory of Asset Pricing

November 1, 2017

Primary dealers are large and sophisticated financial institutions that operate in virtually the entire universe of capital markets and include the likes of Goldman Sachs, JP Morgan, and Deutsche Bank.
  • In 2011, the top five dealers sold about 50% of total net credit default swap (CDS) protection in the U.S.
  • In the corporate bond market, more than 95% of bonds are traded in over-the-counter markets by primary dealers.

To determine the influence of these primary dealers, the researchers created a model inspired by intermediary asset pricing theory. Where the original theory used ‘unsophisticated households’ the researchers replaced those few individual investors with data on the dominant market players: the primary dealers.

“The study’s main finding is that the classic risk-return asset pricing trade-off holds remarkably well in the data, once you shift the focus from unsophisticated households to sophisticated intermediaries.”

Specifically, the study shows that shocks to the equity capital ratio of financial intermediaries—primary dealers—possess significant explanatory power for cross-sectional variation in expected returns. This is true not only for commonly studied equity and government bond market portfolios, but also for other more sophisticated asset classes such as corporate and sovereign bonds, derivatives, commodities, and currencies.

“Financial intermediaries are price-setting investors in many asset classes, and therefore the financial soundness of these intermediaries is important for understanding wide-ranging asset price behavior.”

KEY TAKEAWAYS for Managers

  • An intuitive modification to the CAPM that takes into account intermediary capital shocks can provide better estimates of the cost of capital and of the riskiness of investments.
  • The price of risk for intermediary capital shocks is consistently positive and of similar magnitude when estimated separately for individual asset classes.
  • Financial intermediaries are marginal investors in many markets and key to understanding asset prices.
  • A unifying theory of asset pricing may soon replace the current practice of using instrument-specific valuation models.

The authors conclude that assets’ exposure to changes in the capital ratio of primary dealers explains variation in expected excess returns on equities, US government and corporate bonds, foreign sovereign bonds, options, credit default swaps (CDS), commodities, and foreign exchange (FX). The findings lend new empirical support to the view that financial intermediaries are price-setting investors in many asset classes, and therefore that the financial soundness of these intermediaries is important for understanding wide-ranging asset price behavior.

According to Olin professor Asaf Manela, “Our paper belongs to a burgeoning literature on intermediary asset pricing, which highlights the risk appetite of financial intermediaries, rather than that of households, in explaining the pricing behavior of sophisticated financial assets. The empirical success of the intermediary asset pricing model suggests we are closer than ever to a unifying theory of asset pricing, which can replace the current practice of using instrument-specific valuation models.”

Asaf Manela presented his research to alumni and friends in the business community on November 9, 2017.

“Intermediary Asset Pricing: New Evidence From Many Asset Classes”

Authors:

Asaf Manela, associate professor of finance, Olin Business School, Washington University; Zhiguo He, University of Chicago, Booth School of Business, and NBER; and Bryan Kelly, University of Chicago, Booth School of Business, and NBER

Publication:

Journal of Financial Economics, August 2017