2008-01

Working Paper Series

Equity Issues, Market Timing, and Limits to Arbitrage

Borja Larrain.

www.finance.uc.cl · P o n t i f i c i a U n i v e r s i da d C at o l i c a d e C h i l e
 Equity issues, market timing, and limits to arbitrage∗

Borja Larrain†

Abstract

We study equity issues when the capacity of the market to absorb arbitrage risk

is limited and time-varying. The model produces market-timing behavior–that is,

firms issue equity at high prices and low market returns follow active issuance. In the

cross-section, the model predicts that firms with more arbitrage risk are less likely to

issue equity. We find empirically that firms with stocks that have bad substitutes and

are illiquid (i.e., stocks that are harder to arbitrage) are less likely to issue equity, issue

less equity as fraction of their assets, and have higher leverage.

First draft: November 15, 2007

This draft: March 28, 2008

∗
I thank Matías Braun and Jeremy Stein for helpful conversations, and comments from Motohiro Yogo,
and seminar participants at PUC Chile and Universidad de Chile (CEA). Romina Filippi and Felipe Varas
provided excellent research assistance.
†
Pontificia Universidad Católica de Chile, Escuela de Administración, Avenida Vicuña Mackenna 4860,
Macul, Santiago, Chile. Tel: (56 2) 354-4025. E-mail: larrain@post.harvard.edu or blarrain@faceapuc.cl.
 The recent literature on securities issuance is dominated by the fact that firms issue equity
when stock prices are high (see Baker and Wurgler (2000), Choe, Masulis, and Nanda (1993),
Graham and Harvey (2001), and Ritter (2003)). This empirical regularity, also known as
market timing, is strong and not exclusive to the U.S. market (see Henderson, Jegadeesh,
and Weisbach (2006) for international evidence). However, the interpretation of this fact has
produced a heated debate. On one side, the "rational" camp argues that time-variation in
asymmetric information and real options can explain the cycles of prices and issuance that we
observe (see, for example, Korajczyk, Lucas, and McDonald (1991), Li, Livdan, and Zhang
(2007), and Pástor and Veronesi (2005)). On the other side, the "behavioral" camp argues
that this pattern illustrates how managers take advantage of market overvaluation caused
by irrational investors (Baker and Wurgler 2000). The debate is still open for at least two
reasons. First, this debate is intertwined with the ongoing debate about market efficiency;
the behavioral explanation requires some degree of mispricing in order to work. Second, some
argue that the behavioral explanation does not really provide additional testable predictions—
at least with respect to equity issues—and is therefore hard to test and refute (Dittmar and
Thakor 2007).
The purpose of this paper is to build a behavioral explanation for market timing that
at the same time produces new testable predictions. We do this by focusing on limits to
arbitrage, which is the second ingredient needed in any behavioral theory since frictionless
arbitrage eliminates mispricing (see Barberis and Thaler (2003) and Shleifer (2000)). One
advantage of this focus is that, out of the two behavioral ingredients, limits to arbitrage has
received more support in the literature (Hong and Stein 2007). Moreover, we test the new
predictions of the model and we find support for them.
The absence of perfect substitutes for a stock is the root of limits to arbitrage (see
Scholes (1972), Shleifer (1986), and Wurgler and Zhuravskaya (2002)). If investors cannot
build portfolios that replicate mispriced assets then there is a residual, and unhedgeable,
risk in an arbitrage trade (i.e., selling or buying the mispriced asset and doing the reverse

2
transaction with the replicating portfolio). The residual risk is usually called "arbitrage risk".
Arbitrage risk plus the arbitrageurs’ risk aversion implies that the market has a limited
capacity to absorb equity, i.e., demand curves for stocks are downward sloping (DeLong,
Shleifer, Summers, and Waldmann 1990). Intuitively speaking, stock prices have to fall in
order for investors to hold a larger quantity of arbitrage risk.
In a dynamic setting, the demand and the supply of risk grow simultaneously. Demand
grows as the base of arbitrageurs expands. This expansion increases the absorption capacity
of the market by spreading risk among more investors, and leads to higher prices. As prices
climb, firms issue equity to take advantage of the new spare capacity: equity can be issued
with a smaller price impact and projects can be financed more cheaply. Eventually, the
increase in supply causes the price level to fall once the risk-absorption capacity is exhausted.
We show that the amplitude of the cycle of prices and equity issues depends importantly
on the persistence of the shocks to arbitrageurs. If shocks are highly persistent we observe
long periods of positive returns followed by a wave of equity issues, which then leads to a
prolonged fall in the price level. This is precisely the stylized fact that has been documented
empirically. The element that separates our explanation from others is that, in our model,
high prices are a sign of spare absorption capacity for arbitrage risk. Supply growth (i.e.,
equity issues) limits the operation of arbitrageurs by increasing the amount of risk that they
have to hold.
Our explanation has a subtle, although important, difference with the explanation of
Baker and Wurgler (2000). Their argument is that cycles of hot and cold markets are given
by time variation in investor sentiment: firms issue equity when irrational investors overvalue
stocks and stop issuing when optimism disappears. In our model, investor sentiment is a
constant threat of future mispricing. This threat does not vary in time. Rather, it is the
capacity of rational investors to absorb the sentiment or arbitrage risk that varies in time.
Of course, both explanations complement each other and have mispricing as a main element.
The focus on limits to arbitrage provides new empirical predictions with respect to equity

3
issues. These predictions refer to the cross-section of issuers once we control for the aggregate
market timing. A straightforward prediction is that bigger firms are less likely to issue
additional equity. This is a consequence of the downward-sloping nature of demands for
stocks. We test this prediction by estimating the effect of firm size on the likelihood of issuing
new equity. We find strong support for our hypothesis, which is perhaps not surprising given
the positive effect of size on leverage documented by the empirical capital structure literature.
However, it has been hard to reconcile the size effect with traditional theories of financing
decisions as illustrated by Rajan and Zingales (1995): "We have to conclude that we do not
really understand why size is correlated with leverage (p. 1457)." Our model provides a new
and simple explanation for this robust empirical finding.
A second prediction is that firms with stocks that contain more arbitrage risk are less
likely to issue additional equity. The empirical implementation is less straightforward in this
case, and, perhaps for the same reason, constitutes a more interesting piece of evidence in
favor of the model. In order to construct an empirical proxy for arbitrage risk we examine
the availability of substitutes for a stock, which constitutes the root of limits to arbitrage.
We follow the intuition of Wurgler and Zhuravskaya (2002) who measure substitutability
with the residual variance of the regression of a stock return on the returns of its three most
correlated stocks. The three stocks are generally in the same industry. A stock with higher
residual variance is riskier for arbitrageurs. In a similar vein, we define arbitrage risk as the
residual variance of the regression of a stock return on its industry return. This is a slightly
simpler definition, but one that allows us to implement the idea to a broad universe of stocks
like CRSP (Wurgler and Zhuravskaya (2002) study only additions to the S&P 500). At the
same time, this definition is consistent with the fact that many arbitrageurs are industry
specialists and therefore they look for substitutes within these market segments. We find a
strong and negative effect of this proxy of arbitrage risk on the likelihood of equity issues.
Firms with high residual variance issue less equity and more debt as fraction of assets, and
have overall higher leverage ratios than other firms. This means that firms that deviate more

4
from their industries, and are therefore more risky for arbitrageurs, shy away from equity
issuance as a source of funds.
We also find a positive effect of liquidity (a stock’s average turnover) on the probability
of issuing equity. Illiquidity can limit arbitrage by extending the presence of mispricing.
These results control for standard variables included in capital structure regressions such as
tangibility, profitability, book-to-market ratios, and cash-flow volatility. Therefore, we do not
rule out the influence of asymmetric information (Myers and Majluf (1984)’s pecking order
theory), bankruptcy costs, agency problems, or other classical theories of financing decisions.
Instead, we think of arbitrage risk as a cost of equity financing that is complementary to
these other costs already studied in the literature.
Besides the results concerning market timing and the motives for issuing equity, the
model has some interesting implications for asset pricing. So far the price impact of limits
to arbitrage has been explored in models with fixed asset supply (see Shleifer (2000) for
an overview). In a model with fixed supply, prices converge to fundamentals (rational risk-
adjusted values) if the base of arbitrageurs grows indefinitely. The demands for individual
stocks also get flatter as the risk is spread among more investors. In the model with variable
supply, firms issue equity to take advantage of the risk-bearing capacity that is created by
the expansion of the investor base. As a consequence, prices stay away from fundamentals,
even in the long run and with an infinitely large pool of rational investors, because the
increase in supply constantly adds arbitrage risk to the market. The demands for individual
stocks still get flatter as the investor base grows, because any single stock is insignificantly
small with respect to the market, but they become flat at a level that represents a discount
from fundamentals. This is reminiscent of the possibility that the market presents "micro
efficiency and macro inefficiency", as argued by the behavioral literature (see Lamont and
Stein (2006) and Summers (1985)). Simply put, the aggregate price level can be far away
from fundamentals (macro inefficiency) even if markets appear to be efficient at the level of
individual stocks (micro efficiency or "flat demands").

5
 The rest of the paper is organized as follows. Section 1 presents a dynamic model of equity
issues with limits to arbitrage. Section 2 summarizes the main empirical predictions, which
then guide the empirical work in section 3. Section 4 concludes. The appendix contains all
proofs and detailed explanation of the construction of variables used in the empirical section.

1 Equity Issues in a Model with Limits to Arbitrage

The key elements of the model are taken from DeLong, Shleifer, Summers, and Waldmann
(1990). The source of arbitrage risk is a group of investors with biased perceptions about
asset values, i.e., investor sentiment. Rational investors cannot hedge this risk with other
securities. In principle, diversification could make arbitrage risk purely idiosyncratic. How-
ever, in the model, arbitrage risk has a systematic and undiversifiable component, i.e., it
contains market-wide deviations of prices from fundamentals.1

1.1 Rational and Irrational Investors

There are three types of agents in the economy: specialists (rational investors), retail in-
vestors (irrational investors), and firms. Specialists have correct perceptions about the fun-
damental value of stocks. Retail investors, on the other hand, have biased perceptions about
asset values. Firms issue stocks that are initially bought exclusively by specialists. Spe-
cialists have an exogenous investment horizon of T , a point in which they liquidate their
positions to retail investors. In other words, stocks in this market are sold in two steps:
first, firms sell to specialists, then, specialists sell to retail investors (see Ljungqvist, Nanda,
and Singh (2006) for a similar structure). As we show in the model, retail investors affect
prices even in the first step where they do not participate. The purpose of this structure is
to have long-run arbitrage risk or sentiment, where by long-run we mean an horizon that is
1
An alternative to this model is to argue that, even if arbitrage risk is purely idiosyncratic, rational
investors are not fully diversified because they choose to concentrate on a particular market segment. In this
line, Merton (1987) develops a model of segmented markets that leads to downward-sloping demands.

6
longer than the holding-period planned by rational investors (DeLong, Shleifer, Summers,
and Waldmann 1990).2
The rational risk-adjusted value of stock i is μi .3 The perceptions of retail investors
about the value of the asset are distributed normal with mean μi and variance σ ii , i.e., retail
investors are right on average, but they make mistakes of over- or under-valuation. The
variance σ ii is what we call arbitrage risk. The risk for specialists is that when they liqui-
date stocks in period T they can receive an irrational discount for the asset. The covariance
between arbitrage risk of two assets i and j is σ ij . Arbitrage risk may be correlated across
assets—i.e., it may have a systematic component—because investor mistakes can simultane-
ously affect an entire class of assets (e.g., small stocks, value stocks, etc.).
Throughout the paper we study the market in the interim period before the entry of
retail investors, i.e., t < T . This is a market populated by specialists, but who are limited
in their operation by the threat of future sentiment. This allows us to focus on the con-
sequences of limits to arbitrage without introducing a second behavioral element that can
cause interesting dynamics, namely time-varying sentiment. Time-varying sentiment is the
underlying mechanism in Baker and Wurgler (2000).4

1.2 Evolution of Investor Base

The number of specialists that participate at time t < T is Nt . Each period there is a flow
δ of new specialists that enter the market. We assume that there is random entry and exit
of specialists, which follow a simple AR(1) process:
2
In the model of DeLong, Shleifer, Summers, and Waldmann (1990) long-run arbitrage is obtained by
assuming an overlapping-generations structure, where generations of rational investors die before sentiment
disappears.
3
We assume that all dividends are distributed in a distant period beyond T .
4
One way to incorporate time-varying sentiment to the model would be to assume that every period there
is a given fraction of the population of specialists that has to liquidate positions and sell to retail investors.
In this way, the changes in sentiment of retail investors would be reflected in prices. The liquidity shocks we
consider in our model imply a transference of positions from one specialist to another, but these are fairly
priced because all specialists have unbiased perceptions.

7
 εt = ρεt−1 + ηt , (1)

where ηt ∼ N(0, σ η ). The shock εt can be interpreted as a liquidity shock. If negative, this
shock leads to an early liquidation of positions. This time, it is the case of one specialist
selling assets to another specialist who has unbiased perceptions about asset values.5
As in Merton (1987), we consider the case where firms issuing equity can attract new
specialists, NIt , and expand the investor base. Therefore, the number of specialists in the
market at time t is given by

Nt = Nt−1 + δ + NI,t + εt . (2)

The investor base is a random walk with a constant drift (δ) and jumps (NI,t ). We assume
that N0 is large enough compared to the magnitude of the shocks so that the investor base
always stays positive.

1.3 Portfolio Problem of Specialists

Each specialist buys θit shares of stock i at time t and plans for a buy-and-hold strategy until
time T . Specialists have a mean-variance objective function, in which they show a preference
for mean payoff and a dislike for arbitrage risk captured by the parameter γ (risk aversion).
For a set of Mt stocks listed at time t, with their respective prices Pit , the portfolio problem
is given by the following objective function.6
5
The persistence of the liquidity shocks can be justified along the lines of Shleifer and Vishny (1997).
We can think of specialists as professional intermediaries that handle other people’s money, and who receive
inflows and outflows of funds based on past performance. In such a case, a negative liquidity shock that
lowers the investor base and brings prices down (equation (5)) can produce outflows in future periods and
give persistence to the initial liquidity shock. Therefore, we can think of the persistence of the shock as the
sensitivity of flows to the performance of specialists.
6
This objective function is the same as if we assume CARA preferences and normally distributed payoffs
(see, for example, Grossman and Stiglitz (1980)). The risk-free rate is normalized to zero for simplicity.

8
 X
Mt
γX
Mt X M
t

max θit (μi − Pit ) − θit θjt σ ij . (3)

M t
{θit }i=1 i=1
2 i=1 j=1

Despite the fact that the objective function in equation (3) assumes a buy-and-hold
strategy until time T , specialists will adjust their positions as new specialists and new
assets come into the market. This element of myopic behavior is a common simplifying
assumption in the literature (see, for example, Brunnermeier and Pedersen (2005), Hong,
Scheinkman, and Xiong (2006), Hong and Stein (1999), and Kandel and Pearson (1995)).
Including hedging demands for the potential entry of new demand and new assets complicates
the portfolio problem significantly, but does not affect the main message of the model.
For example, the cross-sectional predictions that we test empirically do not rely on this
assumption. This assumption implies that specialists are not fully rational in our model,
but only boundedly rational. For our purposes, the crucial rational feature they have is the
unbiased perception of fundamental asset values.
The supply of asset i is equal to Qit , and therefore the market clearing condition for each
asset at time t < T is

X
Nt
θhit = Qit . (4)
h=1

The first order conditions of the portfolio problem in (3) together with the market clearing
condition imply that asset prices at time t are given by

γ X
Mt
γσii Qit
Pit = μi − σ ij Qjt − . (5)
Nt j=1 Nt
j6=i

It is useful to interpret equation (5) as a downward-sloping demand function in the

(Qit , Pit ) space. The first two terms of equation (5) represent the intercept of the demand.
The slope of the demand, contained in the last term, is −γσii /Nt . The demand becomes

9
flatter as Nt increases because arbitrage risk is spread among more specialists. Prices differ
from the long-run fundamental μi depending on the risk aversion of specialists, the extent
of the investor base, the composition of asset supply, and the arbitrage risk present in the
market.
In order to streamline notation we define σ imt as as the adjustment for market-wide
misperceptions or investor sentiment that affects asset i

X
Mt
σimt ≡ σ ij Qjt . (6)
j=1
j6=i

1.4 The Decision to Issue Equity

Entrepreneurs own ideas that they sell in the stock market. Entrepreneurs do not have
access to debt financing or have exhausted their debt capacity, so the only source of funds
is the stock market. If the entrepreneur does not issue equity, he receives zero and the idea
is not implemented. If the entrepreneur issues equity, he sells Qi shares at a price Pit . We
assume that the required investment to implement the entrepreneur’s idea is Qi , so Pit is
the market-to-book ratio. The idea or project delivers future dividends that are paid to
shareholders.
The entrepreneur needs to pay a fixed underwriting cost, K, to an investment bank
that helps the entrepreneur to sell the equity issue.7 If the underwriting cost is not paid,
specialists are not aware of the equity issue and there is no demand. The entrepreneur
can also pay a variable cost c for each new specialist added to the investor base. The new
specialists brought in by the investment bank also consider buying the other stocks available
in the market.
If the entrepreneur issues equity, he receives the proceeds from the issue minus the un-
derwriting fees and the initial investment, which we assume to be contractible, i.e., the
7
Gomes (2001) also uses a cost function of equity issues (or external financing) with fixed and variable
costs as we do here. He reports evidence suggesting that fixed costs are substantial, and can represent a
particularly heavy burden for small firms.

10
entrepreneur cannot walk away without investing in the project after he receives funds. Spe-
cialists are price takers so they do not act strategically to extract rents from the entrepreneur.
The entrepreneur also knows the realization of the liquidity shock before issuing.8 Therefore,
the entrepreneur’s payoff when he receives an idea is:

Vit = max [(Pit − 1)Qi − K − cNI,t ; 0] (7a)

{NI,t }

s.t. NI,t > 0 (7b)

Pit from (5) including the new issue. (7c)

The stock price relevant to the entrepreneur is given by equation (5), considering the
new stock as part of the market. The demand is downward-sloping so the equity issue
lowers prices (ceteris paribus). The entrepreneur can reduce the price impact by expanding
the investor base and therefore increasing the risk absorption capacity of the market. The
entrepreneur pays to attract more specialists to the equity issue, who reduce the discount
produced by the threat of future retail investors. The optimal investment in investor base is
given by:

à r !
∗ γQi (σ imt + Qi σ ii )
NI,t = max 0, − Nt−1 − δ − εt . (8)
c

The comparative statics of the investment in investor base are intuitive. Investment is
increasing in specialists’ risk aversion, the size of the project, and the overall arbitrage risk of
the stock. Investment is decreasing in the fee for each new specialist, and in the pre-existing
size of the investor base. Zero investment does not necessarily mean that the entrepreneur
decides to cancel the equity issue. It may be optimal to go public by free riding on the
available investor base.
8
This assumption is not absolutely necessary. We can assume that entrepreneurs base their decisions only
on past prices. For simplicity, we also assume that once a firm is public it never returns to being private nor
repurchases stocks.

11
 We assume that in every period a single entrepreneur is given the option to issue equity,
i.e., one idea is produced every period. This option expires after one period. The arrival
of investment opportunities or ideas is clearly mechanical in the model. Although it is
mechanical, it allows us to isolate the dynamics induced by time variation in the absorption
capacity of the market, which is the focus of the paper. Other models, for example Pástor
and Veronesi (2005), use a similar simplifying assumption with respect to the arrival of ideas.

1.5 Some Constraints on Fundamentals and Demand Growth

We consider the case where firms are sufficiently productive to justify entry in a world
without the threat of irrational investors.

Assumption 1: The fundamental value μi is above the zero-profit price, defined as P̄i ≡
1 + K/Qi .

This assumption implies that all ideas should be implemented in a rational world, i.e.,
a world where Pi = μi , because they represent a profit opportunity. The presence of ir-
rational investors affects real investment decisions by distorting market prices. If μi < P̄i ,
entrepreneurs never issue equity, not even if irrational investors disappear.
The flow δ of new specialists arrives every period irrespective of the number of stocks
listed in the market. It is easy to see from equation (5) that Pi → μi as δ → ∞. If there is no
constraint on the risk-bearing capacity of the market then prices converge to fundamentals.
Even for less than infinite δ, demand growth can be so high that the issuing decision of
entrepreneurs is effectively unconstrained. If δ is high enough, entrepreneurs issue every
time they have the opportunity to do so, which is every period in this model. We want
to focus on the case where demand growth actually represents a constraint to the issuance
decision, at least for some firms, and therefore we make the following assumption.

γσii Qi
Assumption 2: δ < δ̄ i ≡ μi −P̄i
for some i.

12
 Given the entrepreneur’s objective function in equation (7a), it is easy to obtain the
following lemma.

Lemma 1: An entrepreneur issues equity whenever the market pays for the stock a price
above the zero-profit price P̄i .

A second important result is that investment in investor base occurs in the first stages of
a market’s history, if it occurs at all. If the fee for each new specialist (c) is too high, it may
be necessary to wait until the investor base is sufficiently large through its natural growth.
Even if fees are not too high, paying for an expansion of the investor base is not optimal once
the market is sufficiently developed. This occurs because the marginal benefit is decreasing
in the size of the pre-existing investor base and the marginal cost (c) is constant. Therefore,
the incentives to invest in attracting new specialists disappear when the market is sufficiently
large. This is summarized in the following lemma.

Lemma 2: For Nt large enough, entrepreneurs do not invest in expanding the investor
base when they issue equity.

1.6 The Dynamics of Equity Issues and Stock Prices

1.6.1 A Market with Homogeneous Firms

In order to examine the dynamics of prices and equity issues in a simple framework, we
assume that all ideas that are produced have the same characteristics (required investment,
fundamental value and so on). We omit i subscripts in this section.
We first consider the case with no exogenous shocks to the investor base. The absence
of shocks produces cycles that are completely predictable, which is undesirable from an
empirical point of view. However unrealistic, it is a useful first step to understand the
mechanics of the model. We start from t = 0 when there are no listed firms and N0 = 0. In
other words, we study a market from its creation.

13
 The following proposition characterizes the dynamics in this case.

Proposition 1: In the model with homogeneous firms, no shocks to investor base, and
δ < δ̄:
1.1.- After t0 , or the period of the first equity issue without investment in investor base,
γσQ
firms go public at regular time intervals given by t∗ = (μ−P̄ )δ
.
1.2.- Prices fall with an equity issue and rise in between issues. If t1 is a period with an
equity issue, where t0 < t1 < T , then
³ ´
M M −1
P t1 −P t1 −1 = −γQσ Ntt1 − Ntt1−δ 6 0 ,
³1 1
´
Mt1 M
Pt1 +t∗ −1 −P t1 = −γQσ Nt +δ(t∗ −1) − Ntt1 > 0 .
1 1

t
1.3.- For large t, the number of listed firms tends to M̄ = t∗
.

Entrepreneurs issue equity at regular time intervals after they stop investing in investor
base. In this time interval enough new specialists arrive to sustain the new issue at the
zero-profit price.
It is helpful to illustrate Proposition 1 with an example. First, we assume that the cost of
expanding the investor base (c) is so high that entrepreneurs just wait for the investor base
to develop before going public. In Figure 1 it takes eight periods for the investor base to grow
sufficiently to support a new issue, so t∗ = 8. Each fall in the market price is given by a new
equity issue, and prices rebound in between issues. The impact of an issue is smaller as the
market develops, and the price level converges towards the zero-profit price of $1.15. Note
that even if the current price of listed firms is above the zero-profit price, an entrepreneur
who has an idea can decide not to go public. The entrepreneur knows that by issuing equity
it takes some of the risk-bearing capacity of the market and the resulting price is not high
enough.
Figure 1 also shows an example with investment in investor base. For this set of para-
meters, the last entrepreneur that invests in expanding the investor base issues equity ten
periods after the start of the market. The first issue without investment is in period 17

14
(i.e., t0 = 17). Except for the first two issues the rest is analogous to the case without
investment. When entrepreneurs expand the investor base their impact on the other stocks
listed is smaller than when there is no investment. This happens because the other stocks
also benefit from the expansion of the investor base. Of course, the entrepreneurs issuing
obtain better prices than when investment is more expensive.
Figure 2 shows comparative statics for different values of risk aversion. Higher risk
aversion implies that specialists are willing to hold less risk. Therefore, it takes longer
for the market to support a new asset and cycles are more pronounced. Prices have to
increase by more in order to trigger a new issue in the case with higher risk aversion. If the
required investment to implement an idea becomes bigger (higher Q), cycles also become
more pronounced for a similar reason.
If we add shocks to investor base the model behaves in a less predictable way, although
the underlying mechanics are similar. Now an equity issue is not necessarily associated with
a negative price change when it enters the market. This is important because in real markets
we often see active issuance and positive returns at the same time. Empirical evidence is
mostly about a negative correlation between issuance activity and future returns. In this
model we can observe an increase in asset supply and a simultaneous positive market return
if the shock to investor base is sufficiently large.

Proposition 2: In the model with homogeneous firms and δ < δ̄, we observe an increase
in the price level at the time of an equity issue (with no investment in investor base) if the
shock to investor base is sufficiently large, i.e., if εt > Nt /Mt − δ. Otherwise, the price level
falls.

The term Nt /Mt represents the current balance between demand and supply. If Nt /Mt
is low, so the risk-bearing capacity of the market is low, then almost any expansion of the
investor base will increase prices. If Nt /Mt is high (imagine infinite), then prices can only
fall as a firm issues equity. Figure 3 illustrates this proposition with an example in which

15
the shock to investor base is white noise (ρ = 0; σ η = 1). We observe cycles in prices and the
parallel cycles in equity issues. Prices fall below the zero-profit threshold after bad shocks,
something that we did not observe in the case without shocks to investor base. Firms issue
equity after a succession of positive returns, but only if these positive returns push the price
level above the zero-profit threshold. Positive returns by themselves do not lead to equity
issues as seen, for example, between t = 250 and t = 300 in Figure 3. Because of this
threshold effect and the possibility of large shocks (proposition 2), the correlation between
equity issues and the contemporaneous market return is not necessarily negative as it was
in the case without shocks.
We plot impulse responses in Figure 4 to illustrate the impact of shocks. First we study a
positive shock in t = 1 when there are no listed firms. This shock accelerates the development
of the market. For instance, the first issue comes in t = 2 instead of t = 6 as it was in the
baseline case. The dynamics remain the same except for this difference. A shock can arrive
in t = 30 when the market is already up and running (Figure 5). In particular, we show
a shock that is sufficiently large according to Proposition 2. Two more entrepreneurs issue
equity in consecutive periods as a result of the shock. The shock is large enough to push
the price level up after the first new issue. After the second new issue the price level falls as
the risk-bearing capacity is squeezed. Prices then go back to similar cycles as in the baseline
case, although the price level does not reach the same peaks because the market is bearing
more risk.
Figure 5 also presents the impulse response to a shock in t = 30 that persists (ρ = 0.9).
The positive shock produces an increase in prices that is accompanied by a wave of issues.
Prices fall after a few periods following the shock because the new equity is too much for
the market to bear. The transition is smooth because of the persistence of the shock. We
can summarize this effect more formally with the following proposition.

Proposition 3: A one-time and sufficiently large shock εt that persists according to the
autocorrelation coefficient ρ, generates a wave of equity issues until period t+k, where k > 1.

16
Prices increase between periods t and t + j, where j 6 k, and decrease afterwards.

Figure 6 shows a simulation for the baseline case assuming an autocorrelation of 0.9.
We see more pronounced cycles in prices and issues when compared to Figure 3 where
shocks have no persistence. Waves are more clearly marked and more extended. Equity
issues follow a run-up in market prices. Prices decline and issuance volume dries up only
after some periods. The correlation between the price level and equity issues is 0.44 in this
example. The correlation between the contemporaneous change in the price level and equity
issues is only 0.01. The correlation between the lagged price change and equity issues is 0.09
and between the forward change and equity issues is −0.11. The correlations of issuance
activity and price changes (returns) are smaller than the correlations with the price level,
which is a feature of the model that mirrors the empirical evidence discussed later.

1.6.2 A Market with Heterogeneous Firms

We assume that there are styles of ideas, and that all ideas within each style are the same
in terms of required investment and payoff characteristics. Here we consider the case with
two styles, x and y, although the case with more styles is straightforward. We assume that
every other period an entrepreneur receives an idea of style x. In the interim period, an
entrepreneur receives an idea of style y. Investment opportunities keep alternating between
the two styles. We use the notation Mst for the number of listed stocks of style s at time t.
In this case we define the market price index as the weighted average of prices of each style:

Qx Mxt Qy Myt
Pmt = Pxt + Pyt (9)
Qx Mxt + Qy Myt Qx Mxt + Qy Myt

In figure 7 we show an example. The only difference between the two styles is that firms
y contain more arbitrage risk (higher σ), which explains why there are fewer y-firms than
x-firms. Firms y face a steeper demand and are more sensitive to market-wide sentiment,
therefore it is relatively harder for them to issue equity. Since both styles share the same

17
base of investors they tend to issue equity around the same time when there are positive
liquidity shocks.
As suggested by Figure 7, one advantage of having heterogeneous firms is that we can
study the probability of issuing equity for firms of different characteristics. The following
proposition summarizes this result.9

Proposition 4: In the model with heterogeneous firms and δ < δ̄, the conditional proba-
bility of issuing equity for a firm of style s that faces a market shock εt is
³ γσ smt−1 +γσ ss Qs
´
Pr (P st > P̄ s ) = Pr εt > μ −P̄s
− N −δ .
s t−1

This probability of issuing varies across time and across firms. Time-variation in investor
base (Nt−1 ) affects the probability of any firm that wants to go public. The probability
is higher, irrespective of style, in periods with a broad investor base. This captures the
existence of hot and cold markets. On top of a market-wide effect, some styles are more likely
to issue than others. For example, firms with higher arbitrage risk (σ ss ) or more sensitive
to sentiment (σ smt−1 ) are less likely to issue, even when they share the same investor base of
other firms.

1.7 SEOs

Here we consider the case where listed firms can issue more equity, i.e., firms can receive ideas
after becoming listed companies. We assume that the proceeds from the SEO are invested
in the same style of idea of the initial equity issue of the firm.
The objective function of the firm is slightly different from the case of entrepreneurs we
examined before. Entrepreneurs simply sell ideas in the market and walk away with the
profits. We assume, instead, that firms not only care about the profit to be made in the
SEO, but they also care about the value of outstanding shares (Qi,t−1 ), which can be affected
by the SEO. One way to justify this assumption is to think of an entrepreneur as before,
9
In the case where both styles are constrained by demand growth we can reformulate assumption 1 as
γσ i Qi
δ < δ̄ ≡ 2(μ −P̄i )
.
i

18
but who retains a fraction of the first idea he sold. This retention can be the result of an
incentive contract. We set this fraction equal to one to simplify notation.
The issuing decision has to balance two forces. On one hand, issuing new shares lowers
the price of old shares because of the downward-sloping demand. On the other hand, even
if prices fall, the proceeds from the SEO can compensate for the dilution in value of the
outstanding shares.
The firm’s payoff function when it receives an idea is

Vit = max [(Pit − 1)Qi − K − cNI,t + Pit Qi,t−1 ; P̃it Qi,t−1 ] (10a)
{NI,t }

s.t. NI,t > 0 (10b)

Pit from (5) including the SEO (10c)

P̃it from (5) not including the SEO. (10d)

The investment in investor base is analogous to the case of IPOs. The next proposition
characterizes the decision rule for a firm considering an SEO.

Proposition 5: A firm issues more equity when the market pays for the stock a price above
K γσii Qi,t−1 γσii Qi,t−1
P̄itseo = 1 + Qi
+ Nt
= P̄i + Nt
. This price is higher than the zero-profit price for
an IPO of the same size. The conditional probability of issuing additional equity for a firm
that faces the market shock εt is
³ γσ imt−1 +γσii (Qi +Qi,t−1 )
´
Pr (P it > P̄it ) = Pr εt >
seo
μ −P̄i
−N −δ .
i t−1

The difference with the IPO is that the firm internalizes the negative impact of new
equity on the price of old equity, and therefore it sets a higher price as a benchmark. As the
investor base grows, this extra cost tends to zero and SEOs behave like IPOs. The dynamics
described in the previous section are very similar if we assume that listed firms can issue
more equity at some point after their first issue. Price cycles are initially more pronounced

19
because firms considering SEOs are afraid of diluting the value of old shares. Convergence to
the same cycles of the IPO case happens when there is a sufficiently broad base of investors.
Therefore, all of the intuition we developed for the case of IPOs is also applicable to SEOs.

1.8 Prices with a Large Pool of Specialists

In this section we consider the case of T → ∞, which represents a market where the popula-
tion of specialists is allowed to expand indefinitely before the entry of retail investors. The
results in this section are not necessary for analyzing the dynamics of the model, but are
illustrative of the importance of supply changes in the long-run.

Proposition 6: Stock prices of firms in style s converge to P̄s as T → ∞.

From equation (5) one could think that as Nt increases the discount from fundamentals
goes to zero because arbitrage risk is spread among more specialists. In other words, one
could think that μs is the long-run price. This is not true in this model because the number
of listed firms also increases, putting downward pressure on prices. The market never accu-
mulates too much spare capacity, which is the requirement for prices to reflect fundamentals
only. Supply growth becomes a limit to arbitrage even of the pool of specialist is allowed to
grow indefinitely.
It is worth emphasizing that demand curves for individual stocks become flatter as the
investor base expands (the third term in equation (5) goes to zero). However, the price
implications of limits to arbitrage do not disappear. The number of firms grows with the
investor base and therefore the second term of equation (5) never vanishes. This second
term—the intercept of the demand—captures the systematic component of investor sentiment
that specialists cannot diversify away. We can interpret this result as having micro efficiency
("demands for individual stocks are flat"), while at the same time having macro inefficiency,
in the sense that the aggregate price level is not at the level of fundamentals (see Paul
Samuelson’s quote in Lamont and Stein (2006))

20
 Shleifer (2000) argues that firms issuing equity behave like fully rational arbitrageurs.
Firms issue equity when prices are above the long-run price, just like arbitrageurs if they
can create overpriced assets. This kind of arbitrage has limits in our model—for example,
not all firms can issue simultaneously—but it is a driving force of prices in the long run.
Interestingly, this kind of arbitrage does not drive prices towards fundamentals, but only to
eliminate profits from this activity (Pst = P̄s ).
On the basis of Propositions 1 through 6 we develop the main empirical predictions in
the next section.

2 Empirical Predictions

Some of the empirical predictions are shared with other models. For example, the model
predicts a standard market-timing behavior.

Prediction 1: Firms issue equity when prices are high and prices tend to fall after periods
of active issuance.

Our model explains the cycle of prices and equity issues through variations in the capacity
of arbitrageurs to bear risk. Prices increase when the risk-bearing capacity increases, and
firms issue equity because the market can absorb new shares at a "high price". A high price
is anything above the zero-profit price given by P̄ . The model accounts for the tendency of
firms to issue at high prices like other models (e.g., Dittmar and Thakor (2007)), but also
for the fall in prices after periods of active issuance. In our model the fall in prices is caused
by the same equity issues that squeeze the capacity of investors to absorb risk. This is one
of the differences with the model of market timing proposed by Baker and Wurgler (2000),
where prices fall as irrational optimism disappears. Investor sentiment is not time-varying
in our setup, but a constant threat of future mispricing.

Prediction 2: The relevant benchmark for equity issues is the price level, not necessarily

21
past returns.

Returns can be high for several consecutive periods, but if the price level does not rise
above P̄ it does not trigger an equity issue. Levels are more important than changes, in
contrast to the model of IPO waves of Pástor and Veronesi (2005).
Also in terms of the relevant benchmark, the model shows that equity issues can be
triggered by market-wide overpricing and not necessarily by overpricing of one asset with
respect to other assets (relative overpricing). In fact, we observe market timing even in
a market with homogeneous firms, where there is no relative overpricing by construction.
Baker and Wurgler (2000) and Ritter (2003) also point out the problem of studying relative
overpricing as a driving force of equity issues. This can explain in part the failure of DeAn-
gelo, DeAngelo, and Stulz (2007) to find significant predictive power for equity issues in past
market-adjusted returns.
A third prediction, derived from Proposition 5, relates to the effect of size in equity issues
when looking at a cross-section of firms.

Prediction 3: Bigger firms (firms with higher Qit−1 ) are less likely to issue additional
equity.

This prediction is the quintessential prediction of a model with downward-sloping demand

curves for stocks. It is a well-established fact in the empirical literature that bigger firms
are less likely to issue additional equity, but the reasons for this behavior are not clear (see
Dittmar and Thakor (2007) and Rajan and Zingales (1995)). Our model provides a new
explanation for this strong empirical correlation.
Perhaps the more novel prediction of the model, derived from Propositions 4 and 5, refers
to the impact of arbitrage risk.

Prediction 4: Firms with stocks that contain more arbitrage risk (higher σ ii ) or that are
more sensitive to market-wide sentiment (higher σ im ) are less likely to go public or issue
additional equity.

22
 Firms with more arbitrage risk face steeper demand curves. Firms that are more sensitive
to sentiment face more depressed demands (lower intercept). Both characteristics lead to
a lower propensity to issue. As pointed out by Baker and Wurgler (2007), it is typical to
assume in empirical applications that stocks that are harder to arbitrage are at the same
time more sensitive to market sentiment, and both features here have a similar impact on
equity issues.
This final prediction implies a violation of Modigliani and Miller (1958)’s irrelevance
theorem for capital structure. Two firms with the same risk-adjusted value (μi in the model)
have different incentives to raise external funds through debt and equity if they have different
levels of arbitrage risk or sensitivity to sentiment. Firms with stocks that are difficult to
arbitrage find it harder to issue equity and are more likely to finance a project with debt or
to cancel it. The irrelevance theorem of Modigliani and Miller, which relies on frictionless
arbitrage, falls apart if arbitrage is limited (Shleifer 2000).

3 Equity Issues and Arbitrage Risk

3.1 Market Dynamics

The cycle of prices and equity issues described in prediction 1 has been confirmed empirically
at the aggregate level in the U.S. and other countries (see Baker and Wurgler (2000) and
Henderson, Jegadeesh, and Weisbach (2006)). Figure 8 shows the U.S. history of equity
issues as fraction of total market equity and the aggregate market-to-book ratio, which we
use as a measure of the price level. The raw data is taken from CRSP and we follow the
construction of the series described in Larrain and Yogo (2008) (see Lamont and Stein (2006)
for a similar construction). We do not include IPOs since we use firms that already exist in
CRSP. IPOs, however, represent only a small fraction of the market (see Pástor and Veronesi
(2005)).
The correlation between issuance activity and the market-to-book ratio is 0.69. In other

23
words, periods of active equity issuance, i.e., hot markets, coincide with periods of high
valuation ratios. The correlation between equity issues and the previous year’s change in
the market-to-book ratio, which we call the price change or return, is 0.14. The correlation
between equity issues and the contemporaneous price change is 0.13, but the correlation with
next year’s price change is −0.10. Hot markets are preceded by positive returns and are also
contemporaneous to positive returns, but they are followed by low returns. As implied by
prediction 2, the correlation between issues and the price level is higher than the correlation
between issues and returns.
We can replicate these correlations with simulations of our model. We generate 1,000
random samples of the baseline model with homogeneous firms. Table 1 presents average
correlations of the volume of equity issues with price levels and changes of price levels. The
correlation of equity issues and the price level is positive and large (around 0.5), particularly
for low levels of risk aversion and arbitrage risk. For high risk aversion and high arbitrage
risk we obtain smaller correlations, because equity issues become less sensitive to movements
in the price level if specialists are willing to hold less risk or if there is more arbitrage risk
per stock. The correlation between issues and contemporaneous price changes is positive and
low (less than 0.15), and it is slightly lower than the correlation with lagged price changes.
This illustrates the tendency of firms to issue after good returns. Finally, the correlation
between issues and future price changes is mostly negative and not too large (around —0.10),
which is close to the value found in the data.10
Some authors point out that the ability of a behavioral model to produce market timing
is not enough to accept a behavioral explanation, because models based on rationality also
deliver similar predictions. Moreover, it is argued that the behavioral explanation has been
designed ex-post to match the bullish market of the 1990s (Dittmar and Thakor 2007). One
10
Pástor and Veronesi (2005) argue that the empirical correlation of issuance volume with price levels is
smaller than the correlation of issuance volume with price changes. The key difference with the statistics we
compute is that they use the number of IPOs as fraction of total public firms for their measure of issuance
volume. In other words, their measure does not take into account the size of the issues nor SEOs like our
measure.

24
way to advance in identification is precisely to explore other predictions of the model as we
do next. In particular, we provide evidence in favor of predictions 3 and 4 that deal with the
cross-section of equity issues once we control for the "hotness" or "coldness" of the market.

3.2 Sample of Firms and Capital Structure Variables

Our sample consists of firms listed in Compustat between 1970 and 2005. Stock market
data (returns and turnover) are obtained from CRSP. Financial firms (SIC 6000—6999) and
utilities (SIC 4900—4999) are excluded from the sample. We follow Kayhan and Titman
(2007) in the construction of variables related to capital structure (see the appendix for
details). In particular, we look at net equity issues and net debt issues as a fraction of total
book assets, book leverage, and changes in leverage. We exclude firm-year observations with
negative leverage or leverage larger than one.
In the model, the measure of firm size is the book value of equity, however, it is standard
in the capital structure literature to measure size with (log) sales. It does not make any
difference for our results if we use sales instead of book equity, which is not surprising since
the correlation between them is 0.87 in the sample. We report our results with sales in order
to make our regressions more easily comparable to previous literature.
We also compute a set of standard variables used in capital structure regressions: the
market-to-book ratio, tangibility, return on assets (ROA), and ROA volatility. All variables
are measured at the annual frequency. Our regressions include firms with at least five years
of data since we require five years to compute ROA volatility. We winsorize all variables at
the 1% level to minimize the impact of outliers.

3.3 Empirical Measures of Arbitrage Risk

Arbitrage risk refers to fluctuations in prices that investors cannot hedge with close substi-
tutes. In our model these fluctuations occur because of changes in investor sentiment with
respect to a particular stock. We construct our first proxy for arbitrage risk following the

25
intuition present in Wurgler and Zhuravskaya (2002) that most arbitrage trades occur within
an industry. For example, in order to hedge the risk of buying shares of Ford an arbitrageur
can short shares of General Motors. In this way he protects the portfolio against bad news
about the car industry, although he is still vulnerable to investor pessimism about Ford.11
In order to implement this intuition we first run the following regression,

Ri,t−τ = ai,t + bi,t RF F 48,t−τ + ξ i,t−τ . (11)

where Ri,t−τ stands for the stock return of a particular firm, RF F 48,t−τ stands for the
return on the firm’s industry. For each month t we run this regression with the previous 24
months of returns (τ = 1, ..., 24). We define industries using the 48 industry portfolios of
Fama and French available through Ken French’s website.
Our first measure of arbitrage risk is related to fluctuations in returns that are not
captured by the same industry. In particular, we define residual volatility as the standard
deviation of the residuals in this regression divided by the total standard deviation of the
stock return. The residual volatility can be understood as approximately one minus the
R2 of the regression in equation (11).12 Campbell, Lettau, Malkiel, and Xu (2001) have
documented a slight increase over time in residual volatility for the average firm in CRSP,
as can be seen in Figure 9.
Residual volatility captures the fraction of volatility that is uncorrelated with the same
industry, but it does not necessarily reflect the level of volatility of returns (Ri ) or residuals
(ξ i ). This is important because the level of volatility may contain some biases that we want
to avoid. For example, stock return volatility can be mechanically correlated with leverage
since higher leverage potentially makes dividends more volatile. This channel may induce a
correlation of volatility and financing decisions that does not entail limits to arbitrage. In
our sample, the correlation of residual volatility and total stock volatility is only 0.20, and
11
This example is taken from Barberis √ and Thaler (2003).
12
More precisely, residual volatility is 1 − R2 as we define it. For relatively low R2 , 1 − R2 is a good
approximation.

26
is 0.01 with leverage.
A related measure of firm-specific volatility is proposed by Durnev, Morck, and Ye-
ung (2004).13 They argue that firm-specific volatility is positively related to the efficiency
of investment and therefore that higher volatility reflects more informative stock prices.
Campbell, Lettau, Malkiel, and Xu (2001) and Hou, Peng, and Xiong (2006) dispute this
interpretation because a better flow of information should lead to lower volatility of returns.
Hou, Peng, and Xiong (2006) show in their model that firm-specific volatility increases with
the marginal investor’s overreaction to firm fundamentals, which has the flavor of sensitivity
to sentiment like we propose. However, Dittmar and Thakor (2007) follow up on Durnev
et al.’s interpretation and argue that if higher firm-specific volatility reflects lower informa-
tion asymmetry then it should increase the probability of issuing equity as in the pecking
order. If anything, a pecking order effect of this type biases results against our prediction
of a negative impact of residual volatility (i.e., arbitrage risk) on the probability of issuing
equity.
Durnev, Morck, and Yeung (2004) conjecture that the reason for the increased informa-
tiveness of stock prices is the higher presence of traders with private information (Grossman
and Stiglitz 1980). Even within their interpretation it is reasonable to assume that special-
ists are more likely to avoid stocks with frequent "insider trading" because of fear of being
uninformed themselves. Therefore, higher residual volatility can still be considered as a limit
to arbitrage.
Our second proxy for arbitrage risk is illiquidity. We take the average share turnover of
the previous 24 months as our proxy. As shown by Lo and Wang (2000), there is a substantial
trend in turnover over time as can be seen in Figure 9. Mispricing in illiquid stocks can take
longer to reverse, putting an obstacle to short-selling and the operation of arbitrageurs in
general. A related interpretation of turnover is that it serves as a proxy for the investor
13
Their measure is log[(1 − R2 )/R2 ]. Their version of regression (11) includes industry returns and market
returns. A more important difference, quantitatively speaking, is that Durnev, Morck, and Yeung (2004)
work with industry-level averages of firm-specific volatility while we work with firm-level estimates directly.

27
base (Nt ). In our model, the investor base is common to all firms so it does not provide a
source of cross-firm variation. But in the spirit of Merton (1987)’s model, we can think that
turnover captures the variation of investor base across firms when markets are segmented.
Some recent papers share our interpretation of liquidity as an indicator of the slope of the
demand curve for stocks (Helwege, Pirinsky, and Stulz 2007), although others think of it
is a proxy for information asymmetries in the style of the pecking order theory (Bharath,
Pasquariello, and Wu 2008). In order to be conservative in the interpretation of results, we
focus on residual volatility as our preferred measure of arbitrage risk.
In table 2 we split the sample of firms into two groups according to the median residual
volatility and median liquidity each year. Then for each group of firms we provide medians
of different variables across years. The top panel shows that firms with low residual volatility
issue more equity and more debt (as fraction of their assets) than firms with high residual
volatility. Firms with high residual volatility typically increase their leverage, unlike firms
with low residual volatility, and tend to have higher leverage ratios. At the same time, firms
with low liquidity issue less equity and less debt than firms with high liquidity. High liquidity
firms typically increase their leverage by as much as low liquidity firms, but they tend to have
lower leverage ratios. The bottom panel of table 2 shows that firms in these groups differ
in many dimensions simultaneously. Firms with illiquid stocks and high residual volatility
are typically smaller, have lower market-to-book ratios, and slightly lower and more volatile
profitability.
Table 3 presents the matrix of correlations between these variables in our sample. Resid-
ual volatility has a relatively high and negative correlation with firm size (−0.39). This
correlation may contain a mechanical element since, by construction, larger firms are more
highly correlated with their industry because they represent a larger fraction of it. However,
the correlation is of similar magnitude (−0.27) even among firms that represent less than 1%
of their industry’s total market capitalization. Therefore, this high correlation is not purely
mechanical, but reflects a higher exposure to common shocks in bigger firms. Size is also

28
highly and positively correlated with profitability (0.44) and leverage (0.27), and negatively
correlated with ROA volatility (−0.46).

3.4 Regression Results

3.4.1 Logit Analysis of Equity Issuers

We first perform a logit analysis where we explore the determinants of the probability of
issuing equity, following the approach of Dittmar and Thakor (2007). We define a firm-year
observation as an equity issue if the firm has net equity issues above 10% of assets in that
year. This definition implies that approximately 15% of observations are classified as equity
issues. This number is in line with previous research; for example, Hennessy and Whited
(2005) report that the frequency of equity issues in their sample is 10%. We have tried
different thresholds for this definition and results do not vary significantly. If pit is the
probability of firm i issuing equity in year t, then the logit model that we consider is

µ ¶
pit
log = αArbitrage Riski,t−1 + β 0 Xi,t−1 + γLeveragei,t−1 + δ t + λi . (12)
1 − pit

Our main variable of interest is the proxy for arbitrage risk, which is measured with
data up to December of year t − 1. The vector Xi,t−1 contains firm size and the control
variables already mentioned, also measured in year t − 1. We include past leverage to control
for rebalancing motives in the style of the trade-off theory. The year fixed effects (δt ) are
motivated by the time-varying nature of the probability in Proposition 4. These effects
capture the market-wide propensity to issue (i.e., whether it is a hot or cold market). The
model also includes firm fixed effects (λi ). We tried a logit model with industry fixed effects
rather than firm fixed effects and results are basically unchanged. The t-statistics that we
report are robust to heterogeneity and clustered by firm.
Table 4 shows results for the logit regression. Residual volatility significantly reduces

29
the probability of an equity issue, while liquidity has the opposite effect. A one-standard-
deviation increase in residual volatility (0.12) reduces the probability of issuing equity from
15% to 13% holding constant the other covariates. A one-standard-deviation increase in
liquidity (0.99) increases the probability of issuing equity from 15% to 20% holding constant
the other covariates. Adding the firm fixed effects has little impact on the significance of
the coefficients of arbitrage risk. The only coefficient that changes significantly is leverage
which becomes negative and only marginally significant once the fixed effects are included.
We confirm the negative effect of firm size on the likelihood of equity issues, as in previous
research (for example, Dittmar and Thakor (2007)), although our interpretation focuses on
the downward-sloping nature of demand curves.
The positive effect of the market-to-book ratio has also received plenty of attention in the
literature. In our model, this ratio corresponds to the price level for a particular stock, and
therefore it captures market timing above and beyond the aggregate hotness or coldness of
the market captured by the year fixed effects. Our interpretation is that a high price reflects
the expansion of the investor base, although it may also proxy for the effect of Tobin’s Q
on investment. We think that the market-to-book ratio does not allow us to separate the
behavioral and rational motives for equity issues as clearly as arbitrage risk.

3.4.2 Equity and Debt Issues

In the model, the required investment and therefore the amount of financing that is needed
is an exogenous variable. This allows us to focus on the probability of issuing equity in a
simple way. In practice the amount and the composition of financing (debt vs. equity) can
also be choice variables. We explore the effect of arbitrage risk on these other dimensions
using panel regressions with the same set of explanatory variables as the logit model. The
dependent variables are net equity or net debt issues as a fraction of total assets of firm i in
year t, and the change in leverage. Table 5 shows results for these regressions.
Residual volatility predicts lower equity issues with a t-stat above 4. The coefficient

30
implies that a one-standard-deviation increase in residual volatility reduces net equity issues
by approximately 0.20% of assets, which is substantial given that the median of net equity
issues is only 0.68% of assets. Higher liquidity does not predict a significantly higher level
of equity issues as we expected. The control variables are all significant expect for ROA
volatility. In particular, small firms with higher market-to-book ratios tend to issue more
equity. Leverage has a positive coefficient showing that highly levered firms tend to issue
more equity to reduce future leverage.
The regression with net debt issues should be the mirror image of the regression for equity
when we think of arbitrage risk. In fact, residual volatility predicts a positive and significant
effect on debt financing, while liquidity predicts a negative and significant effect. A one-
standard-deviation increase in residual volatility increases net debt issues by approximately
0.10% of assets. A one-standard-deviation increase in liquidity reduces net debt issues by
approximately 0.40% of assets. The median net debt issue in our sample is 2.6% of assets.
Smaller firms with with higher market-to-book ratios and more tangible assets also tend to
issue more debt.
In other words, size, market-to-book, and tangibility seem to be indicators of firms that
are more prone to issue any security rather than a preference for issuing equity or debt.
The case of arbitrage risk, in particular residual volatility, is different since it predicts lower
equity issues and higher debt issues, and therefore a preference against equity and in favor
of debt. Leverage also has opposite effects on equity and debt, which can be expected from
the rebalancing of the capital structure towards a target.
The third panel of table 5 shows regressions with the change in leverage as the dependent
variable. The advantage of this regression is that it nets out simultaneous equity and debt
issues in the same firm. When a given characteristic tends to increase equity and debt issues
simultaneously this regression can tell us what effect is stronger. Residual volatility retains
its positive and significant coefficient, meaning that firms with higher arbitrage risk have a
preference for debt instead of equity. A one-standard-deviation increase in residual volatility

31
increases the change in leverage to approximately 0.20%. The median change in leverage in
the sample is 0.10%. The effect of liquidity is not significant in this case. The net effect of
the market-to-book ratio is to decrease leverage, while the opposite is true for tangibility.
Firm size has an insignificant effect on leverage changes suggesting that its negative effect on
equity and debt issues are of similar magnitude. The overall impression from table 5 is that
there is a robust impact of residual volatility on financing decisions, and a milder effect of
liquidity identifiable only through debt financing. The effect of firm size is present in equity
issues, but also in debt issues for reasons that are outside the model we present in this paper.
We can tackle the potential bias due to a mechanical correlation between firm size and
residual volatility by restricting the sample to those firms that represent less than 1% of their
industry’s market capitalization. The results are basically unchanged. For example, in the
regression for net equity issues the coefficient on residual volatility is −0.022 (t-stat= −3.79)
and the coefficient on liquidity is −0.0004 (t-stat= −0.30). The regressions for debt issues
and changes in leverage are very similar to those in table 5. As can be inferred from table
5, a mechanical correlation between size and residual volatility would only bias the results
against our prediction that arbitrage risk has a negative effect on equity issues. Size has
already a negative effect on equity issues, and if residual volatility were simply the inverse
of size we would expect a positive coefficient on this variable in the regressions. However,
we find a strong and negative coefficient in line with the prediction that arbitrage risk, as
proxied by the residual volatility, is an obstacle for equity issues.

3.4.3 Leverage Regressions

Table 6 shows regressions with leverage as the dependent variable. In this case we include
initial leverage, i.e., leverage for the first year that the firm is in the sample, as a control
variable. When we include firm fixed effects we do not include initial leverage in the re-
gression. These two specifications are motivated by Lemmon, Roberts, and Zender (2007)’s
recent paper on capital structure.

32
 We see a positive and highly significant effect of residual volatility on leverage. The
effect of liquidity is negative and also highly significant. Taking the coefficients from the
regressions with initial leverage we obtain that a one-standard-deviation increase in residual
volatility increases leverage by 0.03 from a sample median of 0.45. A one-standard-deviation
increase in liquidity reduces leverage by 0.025.
The signs of the control variables are the same as in other studies of capital structure
except for the volatility of cash flows, which we proxy with the volatility of ROA. We obtain
a positive coefficient on cash flow volatility unlike Lemmon, Roberts, and Zender (2007),
although, as pointed out by Frank and Goyal (2004), the sign of this coefficient is ambiguous
in theory.14

4 Conclusions

This paper presents a model where the joint dynamics of prices and equity issues are driven
by the limited risk-bearing capacity of the market. The sole driving force is the downward-
sloping demand for equity, which can be explained by limits to arbitrage and behavioral
biases present in stock-market investors.
The model replicates some of the features observed in the aggregate cycles of prices and
equity issues. In particular, the tendency of equity to be issued during periods of high
market prices and the fall in prices that follow active issuance. At the same time, the model
provides new cross-sectional predictions, which cannot be derived from other theories of
financing decisions. We find empirically that firms with stocks that are harder to arbitrage—
illiquid stocks with bad substitutes—are less likely to issue equity, issue less equity as fraction
14
The proxy for cash-flow volatility matters for the sign obtained on this coefficient in the leverage regres-
sions. Faulkender and Petersen (2006) and Frank and Goyal (2004) compute asset volatility as the volatility
of stock returns multiplied by the equity-to-assets ratio. They obtain a negative coefficient on asset volatility
in a standard leverage regression, which is perhaps not surprising given the negative and perfect correlation
between leverage and the equity-to-assets ratio. If we include stock return volatility alone in the leverage
regression of table 6 (with firm fixed effects), we obtain a positive coefficient of 0.003 with a t-stat of 14. If
we include asset volatility as defined by Faulkender and Petersen (2006) and Frank and Goyal (2004), we
obtain a negative coefficient of −0.009 with a t-stat of −30. Residual volatility has a positive and significant
coefficient regardless of the proxy used for cash-flow volatility.

33
of their assets, and have higher leverage ratios. These effects do not substitute for standard
variables in capital structure regressions, therefore we view arbitrage risk as a complement to
other costs of equity financing that are derived from asymmetric information, agency costs
(e.g., risk-shifting), and other motives.

34
A Proofs

Lemma 1

∗
Proof. The value function evaluated at Nipo when the price is P̄i,t is

∗
Vi,t = P̄i,t Qi − Qi − K − cNipo

∗
When the firm choose Nipo , it is also possible to choose Nipo = 0, therefore it must be
the case that:

∗
Vi,t = P̄i,t Qi − Qi − K − cNipo ≥ P̄i,t Qi − Qi − K

by definition P̄i,t Qi − Qi − K = 0, then it follows that Vi,t ≥ 0 and the firm goes public.
when Pi,t ≥ P̄i,t

Lemma 2

∗
Proof. According to equation (5) Nipo = 0 only if

s
γQi σ ipo
imt
− Nt−1 − δ − εt ≤ 0
c

Which happens with probability one because Nt → ∞ as t → ∞ (see Hamilton (1994), p.

495).

Proposition 1

∗
Proof. 1.1.- After t0 we have that Nipo = 0, therefore, the value function is given by Vi,t =
Pi,t Qi − Qi − K. By definition we have that P̄i,t Qi − Qi − K = 0, it follows that firm
goes public only if Pi,t ≥ P̄i,t .

35
 Replacing equation 5 we have that the firm goes public only if.

Pmt
γ j=1 Qj σ ij
Nt ≥ K
(13)
μi − 1 − Qi

taking the difference of equation 13 between t + t∗ and t, and also the fact that for
t > t0 , Nt+t∗ − Nt = δt∗ we have that.

γQi σ ii
t∗ =
(μi − 1 − QKi )δ

where we use that σ ij = σ ii and Qj = Qi because the firms are symmetric.

1.2.- For the first part we need to show that

mt1 mt1 − 1
− ≥0
Nt1 Nt1 − δ

this is true if mt1 −Nt1 < 0. We know that mt1 < t1 , because it only will be t1 if the firms
P1
go public every period. Therefore, mt1 − Nt1 < t1 − Nt1 = t1 (1 − δ) − tk=1 ∗
Nipo,k <0

The second part is straightforward because δ(t∗ − 1) > 0 imply that

mt1 mt
∗
− 1 ≥0
Nt1 + δ(t − 1) Nt1

1
1.3.- For all t > t0 we have Mt = t∗
(t − t0 ) + Mt0 , therefore we can write

Mt 1 t0 Mt0
= ∗ (1 − ) +
t t t t

Mt 1 t
which means that t
→ t∗
as t → ∞. It follows that for large t, Mt = t∗

Proposition 2

36
Proof. The price change at the time of an IPO is

µ ¶
Mt + 1 Mt
∆Pi,t = −γQi σ ii −
Nt + δ + εt Nt
³ ´
Mt +1 Mt
This is positive only if Nt +δ+εt
− Nt
< 0 ,which can only happen in the case that

Nt
εt > −δ
Mt

Proposition 3

Proof. First we are going to prove that there is j such that the price increase before t + j
and decrease after t + j. Then we are going to prove that there exist k such that the IPO
wave stop at t + k. Finally we are going to show that j < k
Nt+n
We know from proposition 3 that the price will increase in t + n only if εt+n > Mt+n
− δ.
If theres only one shock at time t then εt+n = ρn ηt and we can write the condition as

Nt+n
ρn η t > −δ
Mt+n

using the fact that Nt+n = Nt + δn and that during the IPO wave Mt+n = Mt + n. We
find that the price will fall only if

ρn ηt Mt + nρn
≤1
Nt + δMt
ρn η t Mt +nρn
Moreover, the sequence Nt +δMt
→ 0 as n → ∞, therefore, there is some j < ∞ such
ρn ηt Mt +nρn
that Nt +δMt
≤ 1 for all n > j.
Second, We know that there is no entry at time t + n only if Pi,t+n ≤ P̄ , where Pi,t+n is
given by

37
 Mt + n
Pi,t+n = μi − γQi σ ii
Nt + δn
γQi σii
Taking the limit we have that Pi,t+n → μi − δ
as n → ∞. In the limit there is no
γQi σii
entry because assumption 2 guarantees that μi − δ
< P̄ . Therefore, there is a k < ∞
such that there is no IPO for t > k.
Finally we have that j < k. Suppose the contrary, this would imply that at t + k − 1
there would be entry and Pi,t+k−1 > P̄ . However at t + k − 1 < j the price is increasing, and
therefore, at t + k we would have that Pi,t+k > P̄ which can not happen because at t + k
there is no IPO.

Proposition 4

Proof. By the participation constraint we have that

Vit = Pitseo (Qi,t−1 + Qi,seo ) − Qi,seo − K = Pi,t Qi,t−1

K (Pit − Pitseo )
P̄itseo = 1 + + Qi,t−1
Qi,seo Qi,seo

using equation (5) we have

K γσii Qi,t−1
P̄itseo = 1 + +
Qi,seo Nt

Proposition 5

Proof. By substitution.

38
 Proposition 6

Proof. We are going to proceed the proof in two steps. First we are going to show that
SMt
j=1Qj σij
Nt
converge to some constant k. Then we are going to show that the value of this
constant has to be such that Ps converge to P̄s .
Let define Xj = 1ipo Qj σ ij where 1ipo is an indicator function that takes the value 1 if
firm j did an IPO and 0 otherwise. Then we can write

PMt Pt
j=1Qj σ ij k=1 Xk
=
Nt N
Ptt
Xk
k=1
=
Nt−1 + δ + εt
Pt
k=1 Xk
= PMt ∗
Pt
j=1 Nj,ipo + δt + k=1 εk
St
k=1 Xk
t
= SMt ∗ St
j=1 Nj,ipo k=1 εk
t
+δ+ t

SMt
PMt ∗ j=1
∗
Nj,ipo
Lemma 2 guarantees that j=1 Nj,ipo is finite, therefore, t
→ 0 as t → ∞. On
St St
Xk k=1 εk
the other hand, by the law of large numbers k=1
t
converge to some constant k and t

converges to 0. Therefore

St
j=1 Xk
t k
lim SMt St =
t→∞ ∗
j=1 Nj,ipo k=1 εk δ
t
+δ+ t

γk
This means that limt→∞ Ps = μs − δ
.
Finally we prove by contradiction that μs − γk
δ
= P̄s . Suppose that k is such that Ps > P̄s
then lemma (1) establish that firms would remain going public indefinitely decreasing Ps .
However, this can not happen because Ps converge. On the other hand, if Ps < P̄s firms
would stop going public indefinitely. However, this can not be the case because the growing
investor base guarantees that at some time it would be profitable to go public. Therefore,

39
the value of k it must be such limt→∞ Ps = P̄s .

B Variable Definitions

Variable definitions are taken from Kayhan and Titman (2007) when available. Annual
Compustat item numbers are provided after the definition.

1. Book equity = Total assets — total liabilities — preferred stock + deferred taxes +
convertible debt = data6 — data181 — data10 + data35 + data79.

2. Market equity = Common shares outstanding * price = data25*data199.

3. Book debt = Total assets — book equity = data6 — book equity.

4. Book leverage = book debt/total assets = book debt/data6.

5. Firm size = natural logarithm of sales = ln(data12).

6. Market-to-book ratio = market assets/book assets = (data6 — book equity + market

equity)/data6.

7. Tangibility = Net property, plant, and equipment/total assets = data8/data6.

8. Return on assets (ROA) = Earnings before interest, tax, and depreciation/total assets
= data13/data6.

9. ROA volatility = standard deviation of ROA using 5 years of past ROA.

10. Net equity issues = (Change in book equity — change in retained earnings)/total assets
= (∆Book equity — ∆data36)/data6.

11. Net debt issues = (Change in total assets — change in book equity)/total assets =
(∆data6 — ∆Book equity)/data6.

40
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 Figure 1: Price dynamics without investor base shocks
The figure shows the market price level in the model with homogeneous firms and no shocks to investor
base. The figure shows the cases with and without investment in customer base. The parameter values are
μ=1.2, σ=0.009, γ=100/9, δ=0.25, Q=1, K=0.15, and c=0.01.

Fig 1: Price dynamics without investor base shocks

1.18

1.17
market price level

1.16
With Investment
Without Invest
1.15

1.14

1.13
5 15 25 35 45 55 65 75 85 95
time
 Figure 2: Comparative Statics
The figure shows the market price level in the model with homogeneous firms and no shocks to investor
base. Risk aversion takes two different values, 11.11 and 20. The rest of the parameter values are μ=1.2,
σ=0.009, δ=0.25, Q=1, K=0.15, and c=0.01.

Fig. 2: Comparative Statics (Risk Aversion)

1.18

1.17
market price level

1.16
risk aversion 11.11
risk aversion 20
1.15

1.14

1.13
5 15 25 35 45 55 65 75 85 95
time
 Figure 3: Prices and equity issues with investor base shocks
The figure shows the market price level and equity issues in the model with homogeneous firms and for a
realization of shocks to investor base that are not persistent. The parameter values are μ=1.2, σ=0.009,
γ=100/9, δ=0.25, ση=1, ρ=0, Q=1, K=0.15, and c=0.01.

Fig. 3: Price dynamics with shocks to investor base

1.16

1.15

1.14
market price level

1.13

1.12

1.11

1.10
50 100 150 200 250 300
time

Fig. 3: Equity Issues

line=equity issue

50 100 150 200 250 300

time

Fig. 3: Number of firms

14

12

10
number of firms

0
50 100 150 200 250 300
time
 Figure 4: Impulse response to investor base shock in t=1
The figure shows the response of prices (P) and number of firms (M) to a one-time shock to investor base
in t=1. The model considers homogeneous firms. The baseline case corresponds to the one shown in Figure
1 with investment. The magnitude of the shock is ε=2.5. The rest of the parameter values are μ=1.2,
σ=0.009, γ=100/9, δ=0.25, ρ=0, Q=1, K=0.15, and c=0.01.

Fig. 4: Impulse response to shock in t=1

1.18 25

1.17 20
market price level

number of firms
1.16 15 P base
P response
M base
1.15 10 M response

1.14 5

1.13 0
1 6 11 16 21 26 31 36 41 46
time
 Figure 5: Impulse response to investor base shock in t=30
The figure shows the response of prices (P) and number of firms (M) to a one-time shock to investor base
in t=30. The model considers homogeneous firms. The magnitude of the shock is ε=2.5. We consider two
different values of the persistence of the shock, ρ=0 and ρ=0.9. The rest of the parameter values are μ=1.2,
σ=0.009, γ=100/9, δ=0.25, Q=1, K=0.15, and c=0.01.

Fig. 5: Impulse response to shock in t=30

1.18 60

50
1.17

40
market price level

number of fimrs
1.16 P rho=0
P rho=.9
30
M rho=0
1.15 M rho=.9
20

1.14
10

1.13 0
1 6 11 16 21 26 31 36 41 46
time
 Figure 6: Prices and equity issues with persistent shocks to investor base
The figure shows the market price level and equity issues in the model with homogeneous firms and for a
realization of shocks to investor base that are persistent. The parameter values are μ=1.2, σ=0.009,
γ=100/9, δ=0.25, N0=10, ση=1, ρ=0.9, Q=1, K=0.15, and c=0.01.

Fig. 6: Price dynamics with persistent shocks

1.16

1.15
market price level

1.14

1.13

1.12

1.11
50 100 150 200 250 300 350 400 450 500 550 600 650 700 750
time

Fig. 6: Equity Issues

line=equity issue

50 100 150 200 250 300 350 400 450 500 550 600 650 700 750
time
 Figure 7: Prices and equity issues with heterogeneous firms
The figure shows the market price level, equity issues, and number of firms in the model with
heterogeneous firms. There are firms of style x and of style y. The parameter values for x-firms are μ=1.25,
σ=0.009, and Q=1, and for y-firms are μ=1.25, σ=0.015, and Q=1. The correlation between firms x and y is
0.5. The rest of the parameters are γ=100/9, δ=0.25, N0=5, ση=0.5, ρ=0.9, K=0.15, and c=0.01.
Fig. 7: Price dynamics with heterogeneous firms

1.20

1.18
market price level

1.16

1.14

1.12

1.10
50 100 150 200 250 300 350 400 450 500 550 600 650 700 750
time

Fig. 7: Equity Issues

line=equity issue

50 100 150 200 250 300 350 400 450 500 550 600 650 700 750
time

Fig. 7: Number of x-firms (dash) and y-firms (solid)

220
200
180
160
number of firms

140
120

100
80
60
40
20
0
50 100 150 200 250 300 350 400 450 500 550 600 650 700 750
time
 Figure 8: Market-to-Book Ratio and Equity Issuance in the U.S. (1927-2004)
The figure shows the aggregate market-to-book ratio and equity issuance as fraction of total market
capitalization for firms in CRSP. Details on the construction of the series can be found in Larrain and Yogo
(2007).

9% 4.5

8% 4.0

7% 3.5

6% 3.0

5% 2.5
Issuance (% Mkt. Cap.)
M/B
4% 2.0

3% 1.5

2% 1.0

1% 0.5

0% 0.0
1927 1937 1947 1957 1967 1977 1987 1997
 Figure 9: Median Residual Volatility and Median Liquidity of Firms (1970-2005)
The figure shows the median residual volatility and median liquidity of firms in our subsample of the
Compustat-CRSP universe. Residual volatility (left scale) is the ratio of the volatility of the stock return
that is not explained by the industry of the firm and the total volatility of the stock. It is computed with the
previous 24 observations of monthly returns. Industries are defined at the level of the 48 industrial
portfolios of Fama and French. Liquidity (right scale) is the average share turnover over the previous 24
months.

1.2 1.4

1.2
1

1
0.8

0.8

Residual Volatility
0.6
Liquidity

0.6

0.4
0.4

0.2
0.2

0 0
1970 1975 1980 1985 1990 1995 2000 2005
 Table 1: Simulation Evidence about Aggregate Cycles of Equity Issues and Prices
The table shows results from 1,000 random samples generated using the model with homogeneous firms
and persistence of investor base shocks. Each random sample has 1,200 months. From each sample we
compute the correlation between equity issues (IPOs as a fraction of total equity outstanding) with the price
level or changes in the price level at different horizons. The correlations are computed using data between
months 200 and 1,200 to allow for an initial period of market formation. The table shows average
correlations across the 1,000 samples. Price changes are computed annually, i.e. between observations
separated by 12 months. Current changes are computed between months t-12 and t; lagged changes are
computed between months t-24 and t-12; and future changes are computed between months t and t+12.
The baseline parameter values are μ=1.2, σ=0.009, γ=100/9, δ=0.25, N0=4, ση=0.5, ρ=0.9, Q=1, K=0.15,
and c=0.01. The top panel shows average correlations for different values of risk aversion, and the second
panel for different values of arbitrage risk. The last panel shows the correlations found in the data between
equity issuance as fraction of total market capitalization and the aggregate market-to-book ratio (or
changes) for firms in CRSP. Details on the construction of the series can be found in Larrain and Yogo
(2008).

γ (risk aversion)
3 5 11 20
Corr( Equity Issues, Price Level) 0.67 0.55 0.29 0.18
Corr( Equity Issues, Lagged ΔPrice Level) 0.09 0.15 0.14 0.10
Corr( Equity Issues, Current ΔPrice Level) 0.03 0.09 0.11 0.05
Corr( Equity Issues, Future ΔPrice Level) -0.13 -0.12 -0.04 0.00

σ (arbitrage risk)
0.006 0.009 0.015 0.018
Corr( Equity Issues, Price Level) 0.41 0.29 0.20 0.17
Corr( Equity Issues, Lagged ΔPrice Level) 0.18 0.14 0.11 0.09
Corr( Equity Issues, Current ΔPrice Level) 0.13 0.11 0.06 0.04
Corr( Equity Issues, Future ΔPrice Level) -0.08 -0.04 -0.01 0.00

Data
1927-2004 1960-2004
Corr( Equity Issues, Price Level) 0.69 0.64
Corr( Equity Issues, Lagged ΔPrice Level) 0.14 0.21
Corr( Equity Issues, Current ΔPrice Level) 0.13 0.25
Corr( Equity Issues, Future ΔPrice Level) -0.10 -0.01
 Table 2: Summary Statistics
The table shows medians of different variables for groups of firms split according to the median residual
volatility and median liquidity in the sample each year. Residual volatility is the ratio of the volatility of the
stock return that is not explained by the industry of the firm and the total volatility of the stock. It is
computed with the previous 24 observations of monthly returns. Industries are defined at the level of the 48
industrial portfolios of Fama and French. Liquidity is the average share turnover over the previous 24
months. All medians are significantly different at the 1% level between high and low groups using the
Wilcoxon Rank-sum test. The data comes from the intersection of Compustat and CRSP in the years 1970-
2005.

Net Equity Issues Net Debt Issues Change in Leverage Leverage

(% Assets) (% Assets)
Low Residual Volatility 0.8% 2.8% 0.000 0.45
High Residual Volatility 0.5% 1.9% 0.002 0.46

Low Liquidity 0.3% 1.8% 0.001 0.47

High Liquidity 1.2% 3.0% 0.001 0.44

Firm Size M/B ROA ROA Volatility Tangibility

Low Residual Volatility 5.59 1.25 0.13 0.04 0.28
High Residual Volatility 4.10 1.15 0.11 0.05 0.25

Low Liquidity 4.78 1.12 0.12 0.04 0.29

High Liquidity 5.11 1.33 0.12 0.04 0.24
 Table 3: Correlation matrix
The table shows correlations between the variables in our sample. The data comes from the intersection of
Compustat and CRSP in the years 1970-2005.

Residual Firm Size M/B ROA ROA Tangibility Leverage Liquidity

Volatility Volatility
Residual Volatility 1
Firm Size -0.39 1
M/B 0.05 -0.14 1
ROA -0.19 0.44 -0.17 1
ROA Volatility 0.18 -0.46 0.34 -0.55 1
Tangibility -0.14 0.15 -0.16 0.19 -0.18 1
Leverage 0.01 0.27 -0.19 -0.04 -0.09 0.12 1
Liquidity 0.02 0.08 0.28 -0.14 0.21 -0.18 -0.14 1
 Table 4: The Effect of Residual Volatility and Liquidity on the Probability of Issuing Equity
The table shows estimation results of the following logit model

Log(p it /1- p it) = αArbitrage Risk i,t-1 + β′X i,t-1+ γLeverage i,t-1 + λ i + δ t,

where p it is the probability of firm i issuing equity in year t. A firm-year observation is defined as an equity issue if the firm has net equity issues above 10% of
assets in that year. Arbitrage risk is measured with residual volatility and liquidity. Residual volatility is the ratio of the volatility of the stock return that is not
explained by the industry of the firm and the total volatility of the stock. It is computed with 24 observations of monthly returns before December of year t-1.
Industries are defined at the level of the 48 industrial portfolios of Fama and French. Liquidity is the average share turnover over the 24 months before December
of year t-1. The vector of controls X contains the market-to-book ratio, firm size, tangibility, return on assets (ROA), and ROA volatility. The model also controls
for past leverage, and it includes firm and year fixed effects (not reported). Standard errors are robust to heterogeneity and clustered by firm. t-statistics are
reported in parenthesis below the coefficients. The data comes from the intersection of Compustat and CRSP in the years 1970-2005.

Logit Equity Issuer

Residual Volatility -1.40 -1.06 -0.97 -0.59

(-9.31) (-6.64) (-5.03) (-2.95)
Liquidity 0.35 0.34 0.82 0.82
(24.55) (23.63) (14.24) (14.09)
M/B 0.39 0.36 0.36 0.23 0.14 0.13
(29.56) (28.01) (27.56) (6.84) (4.45) (4.13)
Firm Size -0.24 -0.26 -0.28 -0.12 -0.17 -0.19
(-24.43) (-27.45) (-27.29) (-6.85) (-8.87) (-9.85)
Tangibility 0.47 0.74 0.69 0.26 0.46 0.44
(6.29) (9.81) (9.18) (2.01) (3.29) (3.18)
ROA -1.90 -1.87 -1.85 -1.09 -0.73 -0.78
(-17.96) (-17.85) (-17.52) (-4.47) (-2.98) (-3.11)
ROA Volatility 1.69 1.13 1.07 3.14 1.64 1.55
(8.23) (5.60) (5.26) (6.70) (3.70) (3.50)
Leverage 1.31 1.47 1.57 -0.44 -0.27 -0.24
(0.07) (20.78) (21.77) (-3.61) (-2.18) (-1.89)

Firm Fixed Effects No No No Yes Yes Yes

# Obs. 82,060 79,138 76,727 82,060 79,138 76,727
# Firms 9,221 8,796 8,737 9,221 8,796 8,737
2
Pseudo R 21% 22% 22% 44% 47% 47%
 Table 5: The Effect of Residual Volatility and Liquidity on the Amount of Equity and Debt Financing
The table shows results from the following OLS regression

Net Equity Issues it = αArbitrage Risk i,t-1 + β′X i,t-1+ γLeverage i,t-1 + λ i + δ t + ε it.

The dependent variable is net equity issues as fraction of total book assets of firm i in year t. The same regression is run for net debt issues and change in
leverage. Arbitrage risk is measured with residual volatility and liquidity. Residual volatility is the ratio of the volatility of the stock return that is not explained
by the industry of the firm and the total volatility of the stock. It is computed with 24 observations of monthly returns before December of year t-1. Industries are
defined at the level of the 48 industrial portfolios of Fama and French. Liquidity is the average share turnover over the 24 months before December of year t-1.
The vector of controls X contains the market-to-book ratio, firm size, tangibility, return on assets (ROA), and ROA volatility. The regression also controls for
past leverage. The regression includes firm and year fixed effects (not reported). Standard errors are robust to heterogeneity and clustered by firm. t-statistics are
reported in parenthesis below the coefficients. The data comes from the intersection of Compustat and CRSP in the years 1970-2005.

Net Equity Issues as % of Assets Net Debt Issues as % of Assets Change in Leverage

Residual Volatility -0.02 -0.02 0.01 0.01 0.02 0.02

(-4.71) (-4.94) (2.04) (2.24) (4.04) (4.29)
Liquidity 0.000 -0.001 -0.004 -0.004 0.001 0.001
(-0.30) (-0.39) (-2.70) (-3.10) (1.59) (1.18)
M/B 0.03 0.03 0.03 0.01 0.01 0.01 -0.01 -0.01 -0.01
(26.09) (25.30) (25.43) (12.80) (12.48) (12.56) (-12.02) (-12.13) (-11.99)
Firm Size -0.02 -0.02 -0.02 -0.02 -0.02 -0.02 0.00 0.00 0.00
(-15.34) (-14.20) (-14.41) (-11.62) (-10.83) (-10.80) (1.16) (0.61) (0.89)
Tangibility 0.05 0.05 0.05 0.08 0.08 0.08 0.03 0.03 0.03
(6.64) (7.27) (6.84) (7.90) (7.66) (7.82) (3.91) (3.79) (3.68)
ROA -0.11 -0.12 -0.12 0.06 0.06 0.06 -0.09 -0.09 -0.09
(-10.04) (-10.37) (-10.49) (6.31) (5.69) (5.82) (-14.01) (-13.32) (-13.24)
ROA Volatility 0.00 0.00 0.01 0.02 0.03 0.03 -0.04 -0.04 -0.03
(0.19) (0.02) (0.33) (0.32) (1.27) (1.45) (-2.44) (-2.36) (-2.15)
Leverage 0.16 0.15 0.16 -0.37 -0.38 -0.38 -0.36 -0.36 -0.36
(24.95) (23.92) (24.40) (-50.37) (-49.04) (-49.01) (-71.01) (-68.54) (-68.76)

# Obs. 82,060 79,138 76,727 82,060 79,138 76,727 82,464 79,539 77,127
# Firms 9,221 8,796 8,737 9,221 8,796 8,737 9,276 8,849 8,791
R2 55% 55% 55% 30% 29% 30% 32% 33% 33%
 Table 6: The Effect of Residual Volatility and Liquidity on Leverage
The table shows results of the following OLS regression

Leverage it = αArbitrage Risk i,t-1 + β′X i,t-1+ γ Initial Leverage i + δ t + ε it.

The dependent variable is book leverage of firm i in year t. Arbitrage risk is measured with residual volatility and liquidity. Residual volatility is the ratio of the
volatility of the stock return that is not explained by the industry of the firm and the total volatility of the stock. It is computed with 24 observations of monthly
returns before December of year t-1. Industries are defined at the level of the 48 industrial portfolios of Fama and French. Liquidity is the average share turnover
over the 24 months before December of year t-1. The vector of controls X contains the market-to-book ratio, firm size, tangibility, return on assets (ROA), and
ROA volatility. Initial leverage is book leverage in the first year that the firm is in our sample. The regressions include year fixed effects, and industry fixed
effects or firm fixed effects (not reported). Standard errors are robust to heterogeneity and clustered by firm. t-statistics are reported in parenthesis below the
coefficients. The data comes from the intersection of Compustat and CRSP in the years 1970-2005.
Leverage

Residual Volatility 0.27 0.25 0.10 0.10

(18.66) (16.72) (12.73) (12.29)
Liquidity -0.03 -0.02 -0.01 -0.01
(-15.72) (-14.28) (-7.59) (-7.55)
M/B -0.02 -0.02 -0.01 -0.01 -0.01 -0.01
(-16.28) (-15.31) (-14.19) (-7.00) (-6.70) (-6.67)
Firm Size 0.03 0.03 0.03 0.02 0.02 0.02
(23.75) (21.86) (25.34) (7.77) (7.84) (8.55)
Tangibility 0.09 0.07 0.08 0.10 0.09 0.09
(8.01) (5.91) (6.42) (7.27) (6.04) (6.19)
ROA -0.30 -0.29 -0.30 -0.24 -0.24 -0.24
(-29.07) (-27.34) (-27.98) (-23.98) (-23.56) (-23.35)
ROA Volatility 0.10 0.15 0.15 0.10 0.12 0.11
(3.91) (6.16) (6.19) (3.92) (4.47) (4.30)
Initial Leverage 0.27 0.25 0.24
(23.41) (21.20) (21.18)

Industry Fixed Effects Yes Yes Yes No No No

Firm Fixed Effects No No No Yes Yes Yes
# Obs. 55,130 50,356 49,913 82,464 79,539 77,127
# Firms 7,569 7,128 7,114 9,276 8,849 8,791
2
R 28% 27% 28% 71% 71% 71%