The Shadow Price of Intermediary Constraints
Limits to the risk-taking activities of financial intermediaries are important for understanding market stability as well as asset prices, yet they remain difficult to pin down. We propose a novel measure of intermediary risk constraints called the interdealer broker (IDB) ratio, which is the percent of total trade volume conducted between dealers using an IDB. Theoretically, when aggregate risk constraints tighten, dealers will use IDBs more in order to redistribute idiosyncratic risk. Empirically, we test our measure in the U.S. Treasury market, where we find that the IDB ratio has a 0.72 correlation with interest rate risk, as proxied by Value-at-Risk. Consistent with a story of risk premia, a one standard deviation increase in the IDB ratio forecasts a 1.8 percentage point higher annual excess return on a five-year bond. This return predictability holds across different fixed income classes, over varying maturities, as well as out-of-sample.