Financial Constraints Risk

Source: Whited, T. M. & Wu, G. (2006). Review of Financial Studies 19(2), 531–559.

TL;DR

Builds an index of financial constraints (the "Whited-Wu index") from a structural investment

model rather than ad hoc proxies, and shows that financially constrained firms' returns **move

together** — there is a common constraints factor — though it carries only a modest, time-varying

risk premium.

What it documents

That financing frictions are a systematic, priced-ish dimension of the cross-section: constrained

firms share exposure to a common factor tied to the tightness of external finance.

How it is constructed

Estimate a structural model of investment under financing constraints via GMM; the Lagrange

multiplier on the financing constraint yields a firm-level constraints index (a function of

cash flow, dividends, leverage, size, sales growth, industry growth).

Form portfolios on the index and test for a common return factor and its premium.

Evidence

Constrained-firm returns comove (a constraints factor exists).

The factor earns a small, not robustly large premium — constraints risk is real but not a

dominant priced factor; the premium varies with macro conditions.

Why it matters

A rigorous, model-based alternative to the Kaplan-Zingales index for measuring financial constraints,

widely used in corporate finance and asset pricing to study how financing frictions affect investment

and returns.

Limitations and risks

The index depends on the structural model's assumptions; alternative constraint measures disagree.

Whether constraints risk is genuinely priced (vs proxying size/distress) is debated.

Key references

Whited, T. & Wu, G. (2006) — Financial Constraints Risk — Review of Financial Studies

Kaplan, S. & Zingales, L. (1997) — Do Investment-Cash Flow Sensitivities Provide Useful Measures of Financing Constraints? — Quarterly Journal of Economics

Lamont, O., Polk, C. & Saá-Requejo (2001) — Financial Constraints and Stock Returns — Review of Financial Studies