Stock Liquidity and Corporate Cash Holdings

Abstract

The paper contributes to the literature on corporate cash holdings by showing that there is a financial markets channel that affects corporations’ cash holdings. Leaning on the literature on stock price feedback to firm fundamentals, we advance the hypothesis that firms with more liquid stocks hold more cash, ceteris paribus, as ammunition to defend against negative cascades or stimulate positive ones. This contrasts with an alternative view that firms with more liquid stocks are less financially constrained and therefore hold relatively less cash. The evidence favors the cascade/cash as ammunition hypothesis, also with respect to its predictions regarding growth opportunities and cash holdings. As a robustness check, we use the introduction of tick size decimalization in 2001 as a natural experiment where liquidity was exogenously shocked. We also find evidence of two-way causality; a higher level of stock liquidity leads to more cash holdings, and vice versa.

Keywords: cascades, cash holdings, feedback, information, Stock liquidity

JEL Classification: G1, G3