Understanding Cash Flow Risk

Abstract

Theory has recently shown that corporate policies should depend on the exposure of firms to short- and long-lived cash flow shocks and the correlation between these shocks. We provide granular estimates of these parameters for Compustat firms using a new filter that uses only cash flow data and the theoretical restrictions imposed by a canonical cash flow model. As predicted by theory, we find that the estimated parameters have first-order effects on liquidity and financing choices, that firms with a higher estimated correlation between shocks implement riskier policies, and that the sign of this correlation determines the cash flow sensitivity of cash.

Keywords: cash flow risk, permanent and transitory shocks, liquidity management

JEL Classification: G31, G32, G35