Market-Clearing Effects of Corporate Financing Decisions on Stock Returns: An Equilibrium Analysis of Levered Firms when Equity Supply is Fixed

Abstract

We analyze how corporate financing decisions affect stock returns in a stochastic Ramsey model. Motivated by stylized facts, we incorporate two distinct features in the model. First, the supply of equity (the number of outstanding shares) is fixed. Second, firms pursue a target leverage ratio, and balance retained earnings against new debt issuance when financing real investments accordingly. We characterize both the time-series and cross-sectional properties of equity returns implied by the model and confront these with historical data. The model contains only a few time-invariant parameters, but is able to match many dynamic properties of returns (e.g., fat tails, variation in mean and volatility, mean reversion, time-varying betas, return predictability). Our findings suggest that the leverage effect needs to play a more prominent role in pricing equity.

Keywords: consumption-based asset pricing, general equilibrium, market clearing, return predictability, leverage effect

JEL Classification: C22, D53, G11, G12, G14