Financial Constraints Risk

Abstract

We construct an index of firms’ external finance constraints via generalized method of moments (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. We explore the impact of firms’ external finance constraints on their stock returns. Motivation for this inquiry starts with a large body of microeconometric studies that have provided some evidence of an impact of external finance constraints on investment. For example, Whited (1992), Bond and Meghir (1994), and Love (2003) show that augmentations of an investment Euler equation that account for financial constraints improve its fit. The question remains whether these effects are priced in asset markets. In other words, do financial constraints affect asset returns; and if so, is this risk diversifiable? To tackle this question, we construct an index of financial constraints based on a standard intertemporal investment model augmented to account for financial frictions. The model predicts that external finance constraints affect the intertemporal substitution of investment today for investment tomorrow via the shadow value of scarce external funds. This shadow value in turn depends on observable variables. Generalized method of moments (GMM) estimation of the model provides fitted values of the shadow value, which we then use as our index. The most important advantage of this approach is its avoidance of serious sample selection, simultaneity, and measurement-error problems via structural