We present a model for the equilibrium movement of capital between markets. Equilibrium conditional mean rates of return vary across markets according to the levels of capital invested in the respective markets. As a matter of supply and demand within each market, that market with the greater amount of capital earns lower conditional mean returns. Given a sufficient disparity in the capital levels in the markets, intermediaries find it optimal to search for investors in the market with “surplus” capital and offer them the opportunity to move their capital to the other market, which offers higher risk premia. Intermediaries charge investors a fee that is based on their gain from the move and based on the degree of competition in the market for intermediation. The equilibrium behavior of intermediaries is solved analytically, and characterized. Competition among intermediaries can in some cases reduce intermediation in equilibrium, relative to the monopolistic case.
This paper is motivated by empirical evidence, some of which is reviewed in the last section, that supply or demand shocks in asset markets, in addition to causing an immediate price response, also lead to adjustments over time in the distribution of capital across markets and adjustments over time in relative conditional mean asset returns, in a way that reflects delays in the adjustments of investors’ portfolios. We are particularly interested in how those adjustments are affected by the endogenous behavior of intermediaries.
In our equilibrium model, the greater the relative difference in capital levels across the markets, the more intensive are intermediaries’ efforts to re-balance the distribution of capital across the markers, and the greater is the rate of convergence of the mean rates of return of different assets toward a common level. We study the impact on capital mobility of search costs, discounting, asset volatility, and other parameters.
An example is the limited mobility of capital into reinsurance markets, documented by Froot and O’Connell (1999), who write: “Our results suggest that capital market imperfections are more important than shifts in actuarial valuation for understanding catastrophe reinsurance pricing. Supply, rather than demand, shifts seem to explain most features of the market in the aftermath of a loss.” In subsequent work, Froot (2001) continues: “We ... find the most compelling (evidence) to be supply restrictions associated with capital market imperfections and market power exerted by traditional reinsurers.”
Download
Capital Mobility and Asset Pricing
