Financially Constrained Stock Returns

Livdan, Dmitry; Sapriza, Horacio; Zhang, Lu

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Financially Constrained Stock Returns

Journal of Finance, Forthcoming

56 Pages Posted: 10 Jul 2008

See all articles by Dmitry Livdan

Horacio Sapriza

Federal Reserve Banks - Federal Reserve Bank of Richmond; Board of Governors of the Federal Reserve System

Lu Zhang

Ohio State University - Fisher College of Business; National Bureau of Economic Research (NBER)

There are 3 versions of this paper

Date Written: July 10, 2008

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.

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

JEL Classification: E44, G12, G31, G32

Suggested Citation: Suggested Citation

Livdan, Dmitry and Sapriza, Horacio and Zhang, Lu, Financially Constrained Stock Returns (July 10, 2008). Journal of Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1157758