Asset Pricing Implications of Firms' Financing Constraints

Abstract

We use a production-based asset pricing model to investigate whether financial market imperfections are quantitatively important for pricing the cross-section of returns. Specifically, we use GMM to explore the stochastic Euler equation restrictions imposed on asset returns by optimal investment behavior. Our methods allow us to identify the impact of financial frictions on the stochastic discount factor with cyclical variations in cost of external funds. We find that financing frictions provide a common factor that can improve the pricing of the cross section of stock returns. In addition, we find that the shadow cost of external funds exhibits strong procyclical variation so that financial frictions are more important when economic conditions are relatively good.

Keywords: Financing constraints, production-based asset pricing, structural estimation, cyclicality, the cross-section of returns

JEL Classification: E13, E22, E32, E44, G12, G31, G32