Real option component of cash holdings, business cycle, and stock returns

Jiun-Lin Chen, Z. Tingting Jia and Ping-Wen Sun

International Review of Financial Analysis, 2016, vol. 45, issue C, 97-106

Abstract: Corporate managers tend to preserve cash with an expectation of a worse economy while spend cash to exercise growth opportunities with a favorable economic condition. Using three empirical proxies (book-to-market ratio, idiosyncratic volatility and return on asset) in the literature, we extract a real option component of corporate cash holdings, serving both functions of precautionary saving and exercising growth options. Our empirical results show this component, in aggregate, increases when the real GDP declines and decreases when GDP inflates. Also, stocks with returns declining more to a shock to the aggregate real option component of cash holdings earn higher future returns. Moreover, stock returns of firms with higher cash holdings positively comove with the shock to the aggregate real option component, suggesting investors prefer to hold firms with higher cash holdings when the economy is deteriorating.

Keywords: cash holdings; real option; factor model; GDP growth rate (search for similar items in EconPapers)
JEL-codes: D92 E32 G12 G31 G32 (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (9)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:finana:v:45:y:2016:i:c:p:97-106

DOI: 10.1016/j.irfa.2016.03.008

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