A Supply and Demand Approach to Equity Pricing

Abstract

We develop a tractable general equilibrium framework providing a direct mapping between (i) the supply and demand for capital at the firm level and (ii) the cross-section of stock returns. Investor behavioral tilts and hedging needs drive capital supply, while firm profitability drives demand. Heterogeneity in supply and demand factors determines the sign of the risk-return relation and generates anomalies such as betting-against-beta, betting-against-correlation, size, value, investment, and profitability. We estimate the supply and demand schedules of over 4,000 U.S. firms and verify that the model accurately predicts the sign of the risk-return relation conditional on characteristics.

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

JEL Classification: G11, G12