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Cash holdings, risk, and expected returns

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  • Palazzo, Berardino

Abstract

In this paper I develop and empirically test a model that highlights how the correlation between cash flows and a source of aggregate risk affects a firm's optimal cash holding policy. In the model, riskier firms (i.e., firms with a higher correlation between cash flows and the aggregate shock) are more likely to use costly external funding to finance their growth option exercises and have higher optimal savings. This precautionary savings motive implies a positive relation between expected equity returns and cash holdings. In addition, this positive relation is stronger for firms with less valuable growth options. Using a data set of US pubic companies, I find evidence consistent with the model's predictions.

Suggested Citation

  • Palazzo, Berardino, 2012. "Cash holdings, risk, and expected returns," Journal of Financial Economics, Elsevier, vol. 104(1), pages 162-185.
    • Handle: RePEc:eee:jfinec:v:104:y:2012:i:1:p:162-185
    DOI: 10.1016/j.jfineco.2011.12.009
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    More about this item

    Keywords

    Expected equity returns; Precautionary savings; Growth options;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing

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