Financial Intermediaries and the Cross-Section of Asset Returns

Abstract

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. Oursingle-factor model prices size, book-to-market, momentum, and bond portfolios with anR2of 77% and an average annual pricing error of 1%—performing as well as standard multifactor benchmarks designed to price these assets.