Cash Holdings And Credit Risk
Intuition suggests that firms with higher cash holdings are safer and should have lower credit spreads. Yet empirically, the correlation between cash and spreads is robustly positive and higher for lower credit ratings. This puzzling finding can be explained by the precautionary motive for saving cash. In the authors' model endogenously determined optimal cash reserves are positively related to credit risk, resulting in a positive correlation between cash and spreads. In contrast, spreads are negatively related to the "Exogenous" component of cash holdings that is independent of credit risk factors.