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Cash Holdings and Credit Risk

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Author Info
Acharya, Viral V.
Davydenko, Sergei A.
Strebulaev, Ilya

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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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7125.

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Date of creation: Jan 2009
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Handle: RePEc:cpr:ceprdp:7125

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Related research
Keywords: Credit spreads; Default; Liquidity; Precautionary savings;

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Find related papers by JEL classification:
G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Capital and Ownership Structure
G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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