This paper examines the relationship between financial constraints and the stock returns explainingthe pricing of stock through financially constrained and unconstrained firms in Pakistan. Threeproxies; total assets, tangible to total assets and cash holding to total assets ratios) have been usedfor financial constraints and the study tried to investigate that either the investors are compensatedfor taking the extra risk or not in Pakistan Stock Exchange (PSX). We find that the financiallyconstrained firms don't earn higher returns when their capital structure is heavy with liquid assetsand their cash flows are more than the unconstrained firms in PSX. Moreover, the time series resultsshowed that the risk-adjusted returns of the most constrained firms give the mix and somewhatnegative and significant and insignificant results for the Pakistani firms listed in PSX sorted based ontangible to total assets and Cash holding to total asset ratios.
Keywords: Asset Pricing, Financial constraints, risk-adjusted performance of portfolios