Financial Constraints Risk
42 Pages Posted: 23 Jun 2003 Last revised: 5 Feb 2012
Date Written: May 12, 2005
We construct an index of firms' external finance constraints via GMM estimation of an investment Euler equation. Unlike the commonly used KZ index, ours is consistent with firm characteristics associated with external finance constraints. Constrained firms' returns move together, suggesting the existence of a financial constraints factor. This factor earns a positive but insignificant average return. Much of the variation in this factor cannot be explained by the Fama-French and momentum factors. Cross-sectional regressions of returns on our index and other firm characteristics show that constrained firms earn higher returns and that the financial-constraints effect dominates the size effect.
Keywords: Financial Constraints, Stock Returns, Undiversifiable Risk
JEL Classification: G12, G31
Suggested Citation: Suggested Citation