Financial Constraints Risk

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. Copyright 2006, Oxford University Press.