Research from B. Palazzo Finds the Biggest Savers are Risky Firms

in Emerging Research, Faculty, Finance, News, Risk Management
February 28th, 2013

Palazzo, B. (2012). Cash holdings, risk, and expected returns. Journal of Financial Economics, 104(1), 162–185.

Palazzo_Finance_Professor_186x240A recent paper by Boston University School of Management’s Berardino Palazzo, an assistant professor of finance, approaches the relationship between an organization’s savings and its vulnerability from a unique angle. His article, “Cash Holdings, Risk, and Expected Returns,” explores the link between a firm’s cash holdings and the broader, systematic risks it faces, rather than focusing narrowly on the relationship between cash holdings and the firm’s specific cash flow volatility, as previous finance studies have done. This study was recently published in the Journal of Financial Economics.

Palazzo follows a recent strand of financial accounting literature to derive a proxy for a firm’s exposure to systematic risk. His findings illustrate how such systematic risk affects firms’ optimal cash holding policies.

The Riskier the Firm, The Higher Its Savings

Palazzo points out that previous studies ignore the overwhelming likelihood that investors are risk-averse. Instead, his paper rests on the assumption that investors are not risk-neutral. “[R]iskier firms,” he writes, “have the highest hedging needs because they are more likely to experience a cash flow shortfall in those states in which they need external financing the most.” Thus, the riskier the firm, the higher its optimal savings are.

Using a data-set of US public companies, Palazzo finds:

  • Changes in cash holdings from one period to the next are positively related to beginning–of–period expected equity returns; firms with a higher expected equity return will experience a larger increase in their cash balance.
  • Using market size and current profitability as measures, or proxies, firms with higher expected profitability have a larger sensitivity of cash holdings to expected equity returns.
  • When using a book-to-market ratio, this correlation is weaker—not a surprise, Palazzo notes, given that the book-to-market ratio is a catch-all proxy for many variables besides future profitability.
  • The higher the correlation between cash flows and an aggregate shock—in other words, the riskier the firm—the more the firm hoards cash as a hedge against the risk of a future cash flow shortfall, meaning the higher the savings.
  • High cash firms have more growth opportunities but lower current profitability and, as a consequence, they are less exposed to a variety of risks. However, such firms earn a larger and significant risk–adjusted return compared to firms with a low cash–to–asset ratio.