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Cash Holdings and Credit Risk
Viral V. Acharya London Business School - Institute of Finance and Accounting; Stern School of Business; Centre for Economic Policy Research (CEPR) Sergei A. Davydenko University of Toronto - Finance Area Ilya A. Strebulaev Stanford University - Graduate School of Business December 1, 2008 Western Finance Association 2008 Meetings Paper 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 Classifications: G32, G33 Working Paper SeriesDate posted: March 22, 2007 ; Last revised: December 14, 2008Suggested CitationContact Information
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