Financial Intermediation and the Market Price of Risk: Theory and Evidence

Abstract

We theoretically and empirically show financial intermediaries affect the price of risk of the overall market. We first study a continuous-time joint dynamic contracting and asset pricing model, whereby households must contract with and incentivize a financial intermediary to access the financial markets. We show the market price of risk in the intermediated economy is decreasing in the households’ absolute- and increasing in the households’ downside-risk aversions over the intermediary’s wealth. To test this prediction, we use volatilities and credit spreads of the financial sector to empirically proxy for these two risk aversions respectively. Time series regressions and cointegration tests show these two variables affect the equity market Sharpe ratio in the sign directions as predicted by the model. Furthermore, we show short-run shocks to these two variables is a priced factor with a large negative risk price in the cross-section of size, book-to-market, momentum, and also 135 equity and non-equity portfolios. Our theory model shows the role of optimal contracts for portfolio choices and asset pricing in an intermediated economy. The empirical results support our theory predictions, and show uncertainty and downside risks of the financial sector affect the overall market in both the time series and cross-section.