Capital Structure and Hedging Demand with Incomplete Markets

In this paper we study the determinants of the capital structure of firms as an equilibrium phenomenon in financial markets. In particular, we focus on  the role of \textit{hedging demand}, in economies where different investors may develop an appetite for different types of securities depending on their risk properties.  To this end we develop and study a general equilibrium model with production and incomplete markets where households differ in their risk--sharing needs. Value-maximizing firms take investors' hedging demand into consideration in their capital structure choices, possibly facing different investors for their bond and equity supply, which affects their  choice of leverage as well as their choice of technology.  We find that as the demand for hedging increases, corporates grow in size, to allow for greater precautionary saving, and issue more debt. How much more, depends on the availability of competing risk-sharing instruments, such as (government--issued) risk--free debt and derivatives. When the capital structure is jointly shaped by hedging demand and supply considerations, the latter, in the form of an asset--substitution problem, we find that (i) agency is relevant only when hedging demand is high and that (ii) larger investors' risk--sharing needs lead to equilibria featuring greater aggregate risk.