Demand Shocks in Equity Markets and Firm Responses

This paper examines how shifts in investor demand influence firm financing and investment decisions. For identification, the paper exploits a large-scale MSCI methodological reform that mechanically redefined the stock weights in major international equity benchmark indexes, changing the portfolio allocation of 2,508 firms across 49 countries. Because benchmark-tracking investors closely follow these indexes, the rebalancing constituted a clean shock to equity demand. The results show that portfolio rebalancing by benchmark-tracking investors generated significant capital inflows and outflows at the firm level. Firms experiencing larger inflows increased equity issuance, even more so debt financing, and real investment. The paper complements the empirical analysis with a simple model of firm financing in which a decline in the cost of equity increases the value of equity and relaxes borrowing constraints. Higher equity valuations allow firms to expand borrowing even without issuing substantial new equity, so debt financing responds more strongly than equity issuance.