In his presentation on September 28, Tobias Adrian explained how active investors and passive investors employ leverage in their portfolios differently when asset prices are rising.  An increase in asset values increases the ability for one to borrow more against those assets and active investors use this opportunity to increase the leverage in their portfolio.  Passive investors do not adjust their portfolios and the increase in asset prices has the effect of decreasing leverage.  In his paper, “Financial Intermediation, Asset Prices, and Macroeconomic Dynamics” by Tobias Adrian, Emanuel Moench, Hyun Song Shin, this change in leverage employed by broker-dealers (active investors) was investigated as a predictor of asset prices and macro variables such as GDP and inflation.

During their investigation of hundreds of variables, including many variables commonly used for asset pricing, the authors found that the annual growth rate of broker-dealer leverage and the quarterly growth rate of shadow bank institutional financial assets were the best indicators for asset prices.  The authors conclude that the predictive power of these variables is derived from them being indicators of risk aversion/appetite.  It is this changing outlook on risk that influences consumption behavior as well as investment behavior which makes these variables also good indicators of macro variables.

When the models used in the above study are compared to other CAPM models, the above models return results with statistics that show a greater explanatory power.  These models can therefore be seen as an improvement on other CAPM models.  However, other CAPM models performed so poorly in various sorting of market data, perhaps it can be concluded that existing CAPM explanations are so insufficient that the results provided in this paper should be consider a new independent starting point.