Financing Shortfalls and the Value of Aggregate Liquidity

Abstract

This paper studies the level and dynamics of the value of aggregate liquidity induced by firms' financing shortfalls. We model liquidity and cash flows as internal funds available for investment in an economy where external funds are costly. We study whether the use of liquidity to hedge investment opportunities can generate substantial liquidity premia with empirically observed countercyclical properties, and show how firms' financial positions affect the value of aggregate liquidity. Cash flows affect the natural supply of liquidity and are procyclical. Thus, we argue that shortfalls between firms' financing needs and available liquid funds are more likely to occur in bad times when current cash flows are low, rendering liquidity premia countercyclical. We investigate the relationship between such shortfalls and the value of aggregate liquidity empirically using Compustat data.

Keywords: liquidity, business cycles, dynamic corporate finance, production based asset pricing

JEL Classification: G12, G32, G35