Financial constraints and stock returns — evidence from Australia

Using multiple discriminant analysis, we construct an index that measures firms' external financial constraints in an Australian setting. We form portfolios of firms based on our financial constraints index and find that financially constrained firms earn lower return than their unconstrained counterparts. Moreover, stock returns of financially constrained firms are found to move together, indicating the potential existence of a financial constraints factor. Neither the variation nor the mean return of the constraints factor are well explained by existing asset pricing models, suggesting an independent role for our financial constraints factor in affecting stock returns.