Investor Demand, Financial Market Power, and Capital Misallocation

40 Pages Posted: 23 Nov 2021

See all articles by Jaewon Choi

Jaewon Choi

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

Mahyar Kargar

University of Illinois at Urbana-Champaign - Department of Finance

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 its 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 instead incentivizes firms to optimally repurchase shares at favorable prices, which can crowd out investment, especially among firms with liquidity constraints. 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 substantially distorts firms' real investment decisions and impedes the efficient capital allocation across firms. Eliminating excess demand reduces dispersion in the marginal product of capital by 10.74% and TFP losses by 16.20%. Investor demand also influence firm size distributions and generates a heavy right tail---large excess demand provides firms with market power and opportunities to profit from their financial market activities, 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

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