Intermediary Funding Cost and Short-Term Risk Premia

Abstract

We build a theory of short-term risk premia dynamics based on funding costs. The theory builds on a framework of intermediary asset pricing in a market microstructure setting. Financial intermediaries facilitate trading by market making. To fund these trading activities, intermediaries earn a risk premium. This risk premium increases in intermediary leverage and asset idiosyncratic risks. We test our theory across multiple asset classes, including equities, bonds, and currencies. Conditional on a large price shock, high intermediary leverage and asset idiosyncratic risk raise short-term risk premia by about 100 to 170 basis points. We also find evidence of risk sharing and capacity constraints among intermediaries. Intermediary leverage and asset idiosyncratic volatility are important factors in explaining the time series of risk premia in equities, bonds, and currencies.