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RFS Advance Access originally published online on January 18, 2006
Review of Financial Studies 2006 19(2):531-559; doi:10.1093/rfs/hhj012
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Right arrow G11 - Portfolio Choice; Investment Decisions
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© The Author 2006. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org.

Financial Constraints Risk

Toni M. Whited
University of Wisconsin

Guojun Wu
University of Houston

Address correspondence to Toni M. Whited, Department of Finance, University of Wisconsin, 975 University Avenue, Madison, WI 53706-1323, or email: twhited{at}bus.wisc.edu.

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.


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