The Risk Premium on Balance Sheet Capacity
Indian Institute of Management Udaipur;
McGill University; Columbia University
25th July, 2017 (Tuesday) at 3:00 PM
Venue : Seminar Room (First Floor)
Department of Economics, Delhi School of Economics
All are cordially invited
We show that exposure to shocks to the balance sheet capacity of US securities broker-dealers carries a significant risk premium. We construct a novel measure of dealer risk appetite and show that it is priced in the cross-section of expected stock excess returns; even after controlling for benchmark risk factors (MKT, SMB, HML, RMW, CMA, MOM and VOL). We document that risk appetite, median book-to-market ratio, the term spread and the difference in market and average excess returns are, independently and jointly, statistically significant predictors of future market excess returns. Armed with these four return-forecasting factors, we estimate dynamic pricing models with constant betas and time-varying prices of risk. We document significant time-variation in the intermediary risk premium and show that it has a natural macro-financial interpretation. In particular, we show that, unlike the premiums on benchmark factors, it is highly procyclical and gets extraordinarily compressed during periods of stock market exuberance such as that of the late-1990s. We find significant macroeconomic information embedded in the intermediary risk premium. Specifically, we show that the intermediary risk premium is both a significant contemporaneous correlate and a significant predictor of quarterly innovations in the US growth rate. We further show that the time-varying intermediary risk premium dwarfs the premiums on benchmark factors. Finally, we construct a factor mimicking portfolio for risk appetite and show that it sports a Sharpe ratio at least twice as large as benchmark factor portfolios.