Investor Demand, Financial Market Power, and Capital Misallocation

46 Pages Posted: 23 Nov 2021 Last revised: 15 Jun 2022

See all articles by Jaewon Choi

Jaewon Choi

University of Illinois at Urbana-Champaign - Department of Finance; Yonsei University - School of Business

Mahyar Kargar

Gies College of Business, University of Illinois at Urbana-Champaign

Xu Tian

University of Georgia - Terry College of Business - Department of Finance

Yufeng Wu

University of Illinois at Urbana-Champaign - Department of Finance

Date Written: November 19, 2021

Abstract

Fluctuations in investor demand dramatically affect firms' valuation and access to capital. To quantify their real impact, we develop a dynamic investment model that endogenizes both the demand- and supply-side of capital. Strong investor demand elevates equity prices and dampens price impacts of issuance, facilitating investment and financing, while weak investor demand incentivizes firms to opportunistically repurchase shares, crowding out investment. We estimate the model using indirect inference by matching the endogenous relationship between investors' portfolio holdings and firm characteristics. Our estimation suggests that investor demand is an important driver of misallocation, compared with real investment and debt market frictions. Eliminating excess demand reduces dispersion in the marginal product of capital by 11.68% and TFP losses by 13.14%. Investor demand also generates a heavy right tail in the firm size distribution---large excess demand provides firms with market power and opportunities to profit from their financial market transactions, contributing to the emergence of superstar firms.

Keywords: investor demand, capital misallocation, demand estimation, financial market power.

JEL Classification: G30, G10, G20, E22

Suggested Citation

Choi, Jaewon and Kargar, Mahyar and Tian, Xu and Wu, Yufeng, Investor Demand, Financial Market Power, and Capital Misallocation (November 19, 2021). Available at SSRN: https://ssrn.com/abstract=3967753 or http://dx.doi.org/10.2139/ssrn.3967753

Jaewon Choi

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
Champaign, IL 61820
United States

HOME PAGE: http://https://sites.google.com/site/jaewchoi1203

Yonsei University - School of Business ( email )

50 Yonsei-ro, Seodaemun-gu
Seoul, 120-749
Korea, Republic of (South Korea)

Mahyar Kargar

Gies College of Business, University of Illinois at Urbana-Champaign ( email )

Champaign, IL 61820
United States

HOME PAGE: http://mahyarkargar.com

Xu Tian

University of Georgia - Terry College of Business - Department of Finance ( email )

620 S Lumpkin St
Athens, GA 30602
United States

HOME PAGE: http://www.xutianur.com

Yufeng Wu (Contact Author)

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
Champaign, IL 61820
United States

HOME PAGE: http://https://business.illinois.edu/profile/yufeng-wu2/

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