Which Intermediary Costs Matter for Asset Prices?

Department: Finance

Speaker: Manav Chaudhary (LSE)

Room: T027

 Which Intermediary Costs Matter for Asset Prices?  

Abstract: 

When intermediaries such as dealers lack the balance-sheet capacity to absorb investor demand, asset prices deviate from fundamentals. Arbitrage spreads (e.g., Treasury-OIS spreads) are widely used to diagnose such distortions. Yet, it is the overall level of prices (e.g., Treasury yields) that ultimately governs borrowing costs and monetary policy transmission, not spreads. It remains unclear whether spreads accurately capture distortions in these levels. We develop a model where intermediaries face two costs: one proportional to portfolio risk, another tied to gross position size. Gross position costs predominantly drive spread distortions; risk costs primarily drive price-level distortions. The theory delivers a sufficient statistic: differences in the rate at which price levels and spreads revert after a demand shock separately identify these costs. We apply this framework to U.S. Treasury and OIS markets using high-frequency demand shocks identified from Treasury auctions. Risk costs dominate on average: demand shocks move yields substantially while leaving spreads largely unchanged. A calibrated model reinforces the disconnect: relaxing position costs such as the supplementary leverage ratio sharply reduces spread volatility with little effect on yield volatility, while easing risk-based costs does the reverse. Overall, spreads alone miss the dominant source of price-level distortions.