The effects of financial constraints on business fundamentals and asset returns : evidence from a small open economy

Abstract

In this thesis we investigate whether financially constrained firms are fundamentally riskier than unconstrained firms, whether this risk is priced in the form of a financial constraint factor, and whether the financial constraint factor represents an independent source of return movements. The investigation will be in the context of the Norwegian economy and securities markets. Using various measures of financial constraints, we form portfolios of constrained and unconstrained firms in a similar fashion to Fama and French (1992). Following Campello and Chen (2010) we estimate differences in the real business risk of constrained and unconstrained firms by regressing their median real operating earnings- and investment growth on macroeconomic and credit market variables. We test whether the risk is priced by subtracting the monthly stock market returns of constrained firms from unconstrained firms, creating a financial constraint factor. Finally, following Lamont et al. (2001), we investigate whether the financial constraint factor represents an independent source of movement in returns by regressing it on benchmark asset pricing models, including Sharpe (1964) and Lintner (1965)’s CAPM, the Fama and French (1992) three-factor model and the Fama and French (2015) five-factor model. We find evidence that financially constrained firms are fundamentally riskier than unconstrained firms, and that this risk is priced in the form of a financial constraint factor. The results point to financial constraints being time-varying and binding more in downturns than expansions. We find that a negative oil price shock is associated with increasing financial constraints in the Norwegian economy. Furthermore, we find that financially constrained firms in Norway behave in a similar fashion to constrained firms in the US, suggesting that financial constraints are not significantly different across various economic settings. Finally, the combined real-financial results point to the existence of a macroeconomy-equity valuation channel along the lines of Gertler and Bernanke (1989).