Financially Constrained Stock Returns

Abstract:     
We study the effect of financial constraints on risk and expected returns by extending the investment-based asset pricing framework to incorporate retained earnings, debt, costly external equity, and collateral constraints on debt capacity. Quantitative results show that more financially constrained firms are riskier and earn higher expected returns than less financially constrained firms. Intuitively, by preventing firms from financing all desired investments, collateral constraints restrict the flexibility of firms in smoothing dividend streams in the face of aggregate shocks. The inflexibility mechanism also gives rise to a convex relation between market leverage and expected returns.

Number of Pages in PDF File: 56

Keywords: debt capacity, investment-based asset pricing, collateral constraints, the cross-section of expected stock returns

JEL Classification: E44, G12, G31, G32

Accepted Paper Series