A Supply and Demand Approach to Capital Markets

Abstract

We model capital markets as a parsimonious system of simultaneous linear equations expressing firm-level supply and demand for financial capital. Investor preferences, biases, and risk assessments drive capital supply, while a firm’s profitability and other characteristics drive demand. Firm sizes and capital costs are endogenously determined in general equilibrium. Using theoretically-motivated instruments, we estimate the supply and demand schedules of over 1,200 U.S. firms. We quantify equilibrium sensitivities of firm size and capital cost to systematic risks, social score, profitability, and asset tangibility. The paper highlights the usefulness of empirical supply and demand systems for corporate finance and asset pricing.

Keywords: Asset pricing, corporate finance, capital allocation, general equilibrium, factor-based investing, anomalies, production economy, sustainable investing

JEL Classification: G11, G12