Working Paper: NBER ID: w16995
Authors: Viral V. Acharya; Sergei A. Davydenko; Ilya A. 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: cash holdings; credit risk; corporate finance; credit spreads
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 reserves (G32) | higher credit spreads (G19) |
| riskier firms (G32) | higher cash reserves (G32) |
| higher cash reserves (G32) | higher probability of default (G33) |
| cash reserves reduce short-term probability of default (G32) | increase long-term probability of default (G33) |
| exogenous variations in cash holdings (G39) | negatively correlated with spreads (G19) |