Efficiency in Firm Financing and Financial Markets

Efficiency is a central tenet of classical finance theory, grounded in the assumption that agents act to eliminate profit opportunities. Real-world markets often deviate from these idealized predictions due to frictions. My dissertation examines such frictions from both corporate and investor perspectives, focusing on their origins, deviations from theoretical benchmarks, and broader impact on financial markets. My first paper explores how information-free demand shocks affect stock prices. Under the efficient market hypothesis, stock prices reflect expected future cash flows discounted for systematic risk, implying nearly flat demand curves—meaning that non-informational demand shocks should not move prices. Yet, demonstrating this empirically requires isolating truly information-free shocks. One prominent setting is the "index effect," where stocks added to or removed from major indices exhibit abnormal returns. If these changes contain no new fundamental information, they challenge the idea of flat demand curves and thus the efficient market hypothesis. However, as the magnitude of the index effect has declined over time despite growing passive investing flows, scholars have debated whether this reflects declining inefficiencies or information in index reconstitutions. To address this, I propose a novel identification approach that shifts focus from the firms added or removed during reconstitution to those index members not directly involved in these events. Since the sizes of added and deleted firms generally differ, the portfolio weights of incumbent firms must adjust to keep the total at 100\%, requiring that passive index trackers alter their demand for incumbent stocks without any new information about them. Consequently, any abnormal returns on these stocks around reconstitution can be linked solely to passive demand shifts. By studying these information-free demand shifts on incumbents' prices, I can estimate what the abnormal returns would be for added and deleted stocks in the absence of an informational component. Comparing the realized abnormal returns on additions and deletions with these counterfactual scenarios enables me to isolate the role of information. By estimating counterfactual abnormal returns for added and deleted stocks based on incumbent behavior, I isolate the informational component of the index effect. I find that post-2000, the index effect is largely driven by passive demand, with information playing a minor role. Specifically: (i) a simple demand-based counterfactual—accounting for time-varying elasticities—can replicate the average effect size and its decline over time; and (ii) the declining effect stems from increasingly flatter demand curves, not improved information efficiency. In contrast, pre-2000 effects were too large to be explained by passive demand alone, suggesting a stronger role for information in earlier periods. My second paper, coauthored with Stefano Rossi and Lorenzo Bretscher, investigates how legal environments shape firms' financing strategies and creditors' responses. Using newly combined datasets, we reconstruct the debt structure of 10,136 firms across 51 countries. We find that debt ownership is most concentrated in civil law countries and most dispersed in common law countries. In strong investor protection environments, firms borrow through both dispersed unsecured debt and concentrated secured bank lending. Where investor protection is weaker, firms respond by borrowing shorter-term and in USD-denominated debt. These patterns are most pronounced among small and medium-sized firms, while large firms tend to attract dispersed debt from international investors—effectively circumventing local institutional constraints. Our work illustrates how legal environments influence firm behavior and how creditors strategically structure ownership to manage the trade-off between strategic default and inefficient liquidation.