Financial Intermediaries and the Cross‐Section of Asset Returns

TLDR

Financial intermediaries frequently trade across markets with sophisticated models, and their high marginal value of wealth—especially during deteriorating funding conditions—suggests a more informative stochastic discount factor than that of a representative consumer. The study constructs an intermediary stochastic discount factor by exploiting leverage shocks of securities broker‑dealers. The authors build the SDF using leverage shocks from securities broker‑dealers, following theoretical guidance. The single‑factor model accurately prices size, book‑to‑market, momentum, and bond portfolios, achieving an R² of 77% and an average annual pricing error of 1%, comparable to standard multifactor benchmarks.

Abstract

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. Our single ‐factor model prices size, book‐to‐market, momentum, and bond portfolios with an R 2 of 77% and an average annual pricing error of 1%—performing as well as standard multifactor benchmarks designed to price these assets.