Asset Pricing and the Credit Market

We study asset pricing and trading behavior in an exchange economy populated by two agents with different risk aversion. We show that the credit market plays a central role in the risk sharing between the two agents. It allows the less-risk-averse agent to borrow in order to take on levered positions in the stock and thus bear more risk. Optimal risk sharing results in the more-risk-averse agent effectively selling covered “call” options to the less-risk-averse agent. As the state of the economy changes, the equilibrium amount of credit in the market also fluctuates, which in turn influences expected stock returns, stock return volatility, the term structure of interest rates, and trading activity in the stock market. We further explore the immediate empirical implication that variation in the size of the credit market is related to variation in expected stock returns. Using various measures of changes in the size of the credit market, we find that they have significant power in forecasting one-year excess returns of the stock market. Our results suggests that the credit sector is of fundamental importance to the behavior of asset prices. First draft: November 2007. Current draft: April 2008. The authors are grateful for helpful discussions with John Cochrane, Jun Liu, Hanno Lustig, and Pedro Santa-Clara, for excellent research assistance from Dongyan Ye, and for comments from seminar participants at the FDIC.