Working Paper: CEPR ID: DP7125
Authors: Viral V. Acharya; Sergei A. Davydenko; Ilya Strebulaev
Abstract: Intuition suggests that firms with higher cash holdings are safer and should have lower credit spreads. Yet empirically, the correlation between cash and spreads is robustly positive and higher for lower credit ratings. This puzzling finding can be explained by the precautionary motive for saving cash. In our model endogenously determined optimal cash reserves are positively related to credit risk, resulting in a positive correlation between cash and spreads. In contrast, spreads are negatively related to the ``exogenous'' component of cash holdings that is independent of credit risk factors. Similarly, although firms with higher cash reserves are less likely to default over short horizons, endogenously determined liquidity may be related positively to the longer-term probability of default. Our empirical analysis confirms these predictions, suggesting that precautionary savings are central to understanding the effects of cash on credit risk.
Keywords: credit spreads; default; liquidity; precautionary savings
JEL Codes: G32; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Higher cash holdings (G32) | Higher credit spreads (G19) |
| Higher cash reserves (G32) | Higher credit spreads (G19) |
| Higher cash reserves (G32) | Reduced probability of default (short term) (G33) |
| Higher cash reserves (G32) | Increased likelihood of default (long term) (G33) |
| Exogenous variations in cash holdings (G19) | Negatively related to spreads (G19) |