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Asset Pricing Implications of Firms' Financing Constraints

João F. Gomes, Amir Yaron and Lu Zhang
The Review of Financial Studies
Vol. 19, No. 4 (Winter, 2006), pp. 1321-1356
Stable URL: http://www.jstor.org/stable/4123475
Page Count: 36
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Asset Pricing Implications of Firms' Financing Constraints
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Abstract

We use a production-based asset pricing model to investigate whether financing constraints are quantitatively important for the cross-section of returns. Specifically, we use GMM to explore the stochastic Euler equation imposed on returns by optimal investment. Our methods can 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 improves the pricing of cross-sectional returns. Moreover, the shadow cost of external funds exhibits strong procyclical variation, so that financial frictions are more important in relatively good economic conditions.

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