Dissecting Excess Volatility: The Impact of Intermediary Constraints

We examine how intermediary constraints contribute to the excess volatility of long-term prices. We propose a term structure model in which risk-averse intermediaries absorb the demand and supply for variance swaps from preferred-habitat investors. Supply shocks affect the term structure by reducing intermediaries' risk-bearing capacity. Due to limited risk-sharing, risk premiums reflect intermediaries' compensation for bearing unshared risks, leading to excessively volatile long-term prices. Consistent with our model, we empirically show that excess volatility occurs mainly in periods when intermediaries are constrained, is not driven by periods of high stock market risk, manifests through excessively sensitive long-term risk premiums, and varies with intermediaries' inventories and the severity of broader intermediary frictions.