A Financial Contracting-Based Asset Pricing Model

I show that an asset pricing model for the equity claims of a value-maximizing firm can be constructed from its optimal financial contracting behavior. Deals between firms and financiers reveal the importance of contractible states for firm's equity value, namely the stochastic discount factor the firm responds to. I empirically evaluate the model in the cross section of expected equity returns. I find that the financial contracting approach goes a long way in rationalizing observed cross-sectional differences in average returns, also in comparison to leading asset pricing models.