Skin in the Game and Equilibrium Asset Prices

I study the asset pricing implications of the presence of active capital. I define active capital as a form of ownership where some owners put skin in the game which makes firms more productive. In general equilibrium, active capital distorts risk sharing: aggregate risk is borne by levered active investors and regular ones are relieved from it. This effect tends to lower the risk price of all shocks. Dynamically, changes in the level of active capital, through deleveraging effects creates additional fluctuations in asset prices. I show that risk and risk aversion are negatively related to the supply of active capital. Fluctuations in active capital are therefore amplified by fluctuations in risk premium. This causes risk premium shocks to command a higher risk price. These two effects help explain the failure of cash-flow risk to explain asset returns and the importance of changes in risk premium. Additionally, it justifies the negative correlation of the quantity of active capital with the risk premium and its role for explaining the cross-section of returns. ∗I thank my advisors Lars Hansen, Zhiguo He, Stavros Panageas and Pietro Veronesi for their continuous guidance. I am grateful for comments and suggestions from Ralph Koijen, Erik Loualiche, Matthew Plosser, Shri Santosh, Harald Uhlig and participants in the Economic Dynamics Working Group at the University of Chicago. Research support from the Stevanovich Center for Financial Mathematics is gratefully acknowledged. †University of Chicago, [email protected]