Surfing the Cycle: Cyclical Investment Opportunities and Firms' Risky Financial Assets

Abstract

This paper studies why non-financial firms invest in risky financial assets. Within a dynamic corporate finance model with macroeconomic fluctuations, we show that firms can use risky financial assets to transfer liquidity from states with low aggregate investment opportunities to states with high aggregate investment opportunities. Specifically, when investment funding demand is more pro-cyclical than profits and external financing is costly, risky financial assets with pro-cyclical returns can be more valuable than risk-free assets in matching internal funding and investment opportunities. Based on U.S. firm data scraped from SEC 10-K filings, we find empirical evidence consistent with this mechanism: (1) time-serially, the value of risky financial assets is positively correlated with the corporate investment rate; (2) cross-sectionally, firms with more pro-cyclical investment funding demand in excess of profits hold more risky financial assets.

Keywords: Business Cycles, Financing Frictions, Cash Holdings, Risky Financial Assets, Machine Learning

JEL Classification: E32, G11, G32