The cost of capital in markets with opaque intermediaries and the risk-structure of interest rates

Mierzejewski, Fernando (2008): The cost of capital in markets with opaque intermediaries and the risk-structure of interest rates.

Abstract

The demand for cash balances of financial intermediaries that establish contractual liabilities with credit-sensitive customers is characterised. As stated by Merton, the success of the business activities of such firms crucially depends on their credit quality, and hence, they are obliged to rely on deposit insurance and capital cushions in order to assure that their promised payments are free of default. Unlike the Merton’s approach, the optimal guaranteeing contract is formulated in actuarial terms in this paper, because in this way the model can be extended to consider the situation of firms that can only hedge up to a limited extent. Within this framework, the equilibrium in the market determines the rate at which a unit of capital is exchange by a unit of risk, or, in other words, it determines the market price of risk. Episodes of liquidity crises are meaningful in this theoretical setting.

• Item Type: MPRA Paper
• Language: English
• Keywords: The cost of capital; Liquidity preference; Monetary equilibrium; Financial instability; Liquidity crises
• Subjects: G - Financial Economics > G1 - General Financial Markets > G14 - Information and Market Efficiency ; Event Studies ; Insider Trading; G - Financial Economics > G1 - General Financial Markets > G15 - International Financial Markets; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E41 - Demand for Money

References

[1] Choi, W.G., and Oh, S., 2003. A Money Demand Function with Output Uncertainty, Monetary Uncertainty, and Financial Innovations. Journal of Money, Credit and Banking 35 (5), pp. 685-709.

[2] Dhaene, J., Goovaerts, M. and Kaas, R., 2003. Economic Capital Allocation Derived from Risk Measures. North American Actuarial Journal 7 (2), pp.44-59.

[3] Friedman, M., 1970. A Theoretical Framework for Monetary Analysis. The Journal of Political Economy 78 (2), pp. 193-238.

[4] Goovaerts M.J., Van den Borre E. and Laeven R., 2005. Managing economic and virtual economic capital within financial conglomerates. North American Actuarial Journal 9 (3), pp.77-89.

[5] Holmstrom, B., and Tirole, J., 2000. Liquidity and Risk Management. Journal of Money, Credit and Banking 32 (3), pp.295-319.

[6] Howells, P. and Bain, K., 2005. The Economics of Money, Bankig and Finance. Prentice Hall.

[7] Hull, J.C., 2000. Options, Futures and Other Derivatives. Fourth Edition. Prentice Hall.

[8] Jensen, M.C., 1986. Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers. The American Economic Review 76 (2), pp. 323-329.

[9] Merton, R.C., 1974. On the Pricing of Corporate Debt: The Risk-Structure of Interest Rates. Journal of Finance 29 (2), pp. 449-470.

[10] Merton, R.C., 1977. An Analytic Derivation of the Cost of Deposit Insurance and Loan Guarantees. Journal of Banking and Finance 1, pp.3-11.

[11] Merton, R.C., 1997. A Model of Contract Guarantees for Credit-Sensitive, Opaque Financial Intermediaries. European Finance Review 1 (1), pp.1-13.

[12] Merton, R.C. and Perold, A.F. (1993). Theory of Risk Capital in Financial Firms. Journal of Applied Corporate Finance 5, pp. 16-32.

[13] Mierzejewski, F., 2006. Optimal Capital Allocation Confronting Bankruptcy and Agency Costs. Bank- en Financiewezen 2006/2, pp. 72-77.

[14] Modigliani, F. and Miller, M.H., 1958. The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review 48 (3), pp. 261-297.

[15] Sharpe, W.F., 1966a. Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk. The Journal of Finance 19 (3), pp. 425-442.

[16] Sharpe, W.F., 1966b. Mutual Fund Performance. The Journal of Business 39 (1), pp. 119-138.

[17] Tobin, J., 1958. Liquidity Preference as Behavior Towards Risk. The Review of Economic Studies 25 (2), pp. 65-86.