Real Option Component of Cash Holdings, Business Cycle, and Stock Returns
32 Pages Posted: 21 Nov 2014 Last revised: 10 May 2019
Date Written: December 16, 2014
Corporate managers tend to preserve cash with an expectation of a worse economy while spend cash to exercise growth opportunities with a favorable economic condition. We hypothesize that there exists a real option component of aggregate corporate cash holdings, serving both functions of precautionary saving and exercising growth options. Consistent with our hypothesis, the empirical results show that this component increases when the real GDP declines while decreasing when the real GDP increases. Stocks with returns declining more to a shock to the real option component of aggregate cash holdings earn higher future returns. Moreover, our results show that stock returns of firms with higher cash holdings positively comove with the shock to the real option component of aggregate cash holdings, suggesting investors prefer to hold firms with higher cash holdings when the economy is bad.
Keywords: cash holdings, real option, factor model, GDP growth rate
JEL Classification: D92, E32, G12, G31, G32
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