Essays on Asset Pricing and Financial Stability

Abstract

My two-essay dissertation revolves around understanding the financial crisis of 2008. First I focus on the repo market, a major funding source of the shadow banking system, and show the repo market can create and amplify the fragility of the system. Then I investigate a broader economy with heterogeneous agents and demonstrate how the dynamics of equilibrium asset prices and wealth distributions are determined. In Essay 1, I develop a dynamic model of collateral circulation in a repo market, where a continuum of institutions borrow from and lend to one another against illiquid collateral. The model emphasizes an important tradeoff. On one hand, easier collateral circulation makes repos liquid and increases steady state investment through several multiplier effects, improving economic efficiency. On the other hand, it can harm financial stability because less capital is sitting on the sidelines waiting for investment opportunities. This fragility is further exacerbated by the endogenous repo spread through a positive feedback loop, and can result in an inefficient repo run. The model is relevant for understanding the repo markets during the financial crisis of 2008. In Essay 2, I study the dynamics of the wealth distribution and asset prices in a general equilibrium model. Agents face heterogeneous portfolio constraints that limit the shares of risky investments relative to wealth. The setup is motivated by empirical evidence that many households do not participate in the stock market and portfolio shares are heterogeneous and persistent conditional on stock market participation. There are two main results. First, one state variable can summarize the wealth distribution regardless of the number of types of agents. Second, when the economy is bad, it becomes more sensitive to additional negative shocks, meaning that not only magnitudes of the shocks but also their frequency matters.