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RFS Advance Access originally published online on March 15, 2006
Review of Financial Studies 2006 19(4):1321-1356; doi:10.1093/rfs/hhj040
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Right arrow E22 - Capital; Investment; Capacity
Right arrow E44 - Financial Markets and the Macroeconomy
Right arrow G12 - Asset Pricing; Trading volume; Bond Interest Rates
Right arrow G32 - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure
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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.

Asset Pricing Implications of Firms’ Financing Constraints

João F. Gomes
University of Pennsylvania and CEPR

Amir Yaron
University of Pennsylvania and NBER

Lu Zhang
University of Rochester and NBER

Address correspondence to João F. Gomes, The Wharton School, University of Pennsylvania, 3620 Locust Walk, Philadelphia, PA 19104, or email: gomesj{at}wharton.upenn.edu.

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. (JEL E22, E44, G12)


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