Precautionary Savings with Risky Assets: When Cash Is Not Cash

• Author: CHRISTOPHER HRDLICKA,THOMAS GILBERT,JARRAD HARFORD,RAN DUCHIN
• Published date: 01 April 2017
• DOI: http://doi.org/10.1111/jofi.12490
• Date: 01 April 2017

THE JOURNAL OF FINANCE •VOL. LXXII, NO. 2 •APRIL 2017

Precautionary Savings with Risky Assets: When

Cash Is Not Cash

RAN DUCHIN, THOMAS GILBERT, JARRAD HARFORD,

and CHRISTOPHER HRDLICKA∗

ABSTRACT

U.S. industrial firms invest heavily in noncash, risky financial assets such as cor-

porate debt, equity, and mortgage-backed securities. Risky assets represent 40% of

firms’ financial portfolios, or 6% of total book assets. We present a formal model to

assess the optimality of this behavior. Consistent with the model, risky assets are

concentrated in financially unconstrained firms holding large financial portfolios, are

held by poorly governed firms, and are discounted by 13% to 22% compared to safe

assets. We conclude that this activity represents an unregulated asset management

industry of more than $1.5 trillion, questioning the traditional boundaries of nonfi-

nancial firms.

AKEY ASSUMPTION IN STUDIES of corporate cash holdings is that industrial firms

invest in actual cash or risk-free, near-cash securities. Recent anecdotal evi-

dence in the press, however, suggests that corporate treasuries have consider-

ably broadened the scope of securities in which they invest. For example, the

article “Google’s Latest Launch: Its Own Trading Floor,” published in Business

Week Online on May 27, 2010, reports that “Google, it turns out, has launched a

trading floor to manage its $26.5 billion in cash and short-term investments .. .

One of the company’s goals is to improve the returns on its money, which until

now has been managed conservatively.”

∗All authors are at the Michael G. Foster School of Business, University of Washington. We

are grateful to two anonymous referees, an Associate Editor, Michael Roberts (the Editor), David

Cordova (tax partner at Deloitte), Harry DeAngelo, Dave Denis, Amy Dittmar, Mike Faulkender,

Laurent Fresard, Ron Giammarino, Todd Gormley, Jay Hartzell, Carolin Pflueger, Lee Pinkowitz,

Bill Resler, Martin Schmalz, Terry Shevlin, Jake Thornock, and Jeff Zwiebel for insightful dis-

cussions and comments. We thank Aaron Burt, Harvey Cheong, Matthew Denes, John Hackney,

Lucas Perin, and especially Rory Ernst for excellent research assistance. We also thank seminar

participants at Carnegie Mellon, City University–Hong Kong, Emory University, Erasmus Uni-

versity, the Interdisciplinary Center Herzliya(IDC), the University of Amsterdam, the University

of Copenhagen, the University of Hong Kong, the University of Kentucky, the University of Utah,

Tilburg University,Tulane University, and WashingtonUniversity in St. Louis and participants of

the ASU Sonoran Winter Finance Conference 2014, the 9th Annual FIRS meetings, the 2014 SFS

Cavalcade, the Pacific Northwest Finance Conference, the 2014 LBS Summer Finance Symposium,

and the 2014 Western Finance Association Meetings for helpful comments. The authors declare

that they have no potential conflicts of interest, as identified in the Journal of Finance Disclosure

Policy, and have received no outside financial support for the research and writing of this paper.

DOI: 10.1111/jofi.12490

793

794 The Journal of Finance R

In this paper, we investigate both empirically and theoretically the compo-

sition, determinants, and implications of financial assets held by nonfinancial

firms. We show that firms hold large portfolios, which comprise a wide range of

financial assets. Apple, for example, holds $121 billion, or 70% of its book as-

sets, in financial assets, placing it among the largest hedge funds in the world.

Collectively, the firms in our sample manage over $1.5 trillion in financial

assets. Despite the similarity to the traditional asset management industry,

the regulation and disclosure requirements of this shadow asset management

industry are minimal.

Our empirical analysis exploits the implementation of Statement of Financial

Accounting Standards (SFAS)No. 157 in 2009, which requires all firms to report

the fair value of major asset classes on their balance sheet.1We collect data

on firms’ nonoperating financial assets that comprise: (1) the balance sheet

accounts “cash and cash equivalents” and “short-term investments,” which

constitute Compustat’s data item CHE, the standard measure of cash holdings

in the literature, and (2) any additional financial assets reported as “long-term

investments” or “other assets,” not considered by prior studies.2We hand-

collect these detailed data on the asset classes that constitute firms’ financial

portfolios from the footnotes of annual reports for all industrial firms in the

S&P500 Index from 2009 to 2012.

Our findings shed new light on both the size and the composition of indus-

trial firms’ financial asset holdings. First, we find that the total value of firms’

financial asset portfolio is 24.6% larger than the traditional measure of cor-

porate cash holdings. This difference stems from the inclusion of long-term

financial assets. Critically, the existing cash literature has implicitly ignored

these financial assets, which can be held to fund real investment opportunities

and mitigate adverse shocks that may arise in the more distant future.

Second, our estimates indicate that firms invest heavily in noncash securi-

ties that are both risky and illiquid. These securities are frequently included

in the balance sheet accounts “cash and cash equivalents” and “short-term in-

vestments,” which make up CHE. This traditional measure of cash holdings is

composed of at least 23.2% risky securities on average.

Third, we show that risky securities represent 38.3% of aggregate financial

asset portfolios, or 5.8% (5.6%) of the aggregate book value (market value of

equity) of industrial firms in the S&P 500 Index. The vast majority of risky se-

curities (roughly 79%) are also illiquid. They include a wide array of securities,

such as corporate debt (23.6%), equity (8.6%), asset-backed or mortgage-backed

securities (8.4%), and government debt excluding U.S. Treasuries (15.3%),

both domestic and foreign. In contrast, safe assets, which represent 61.7%

of aggregate portfolios, comprise money-like securities with minimal risk and

1See paragraph 32 of SFAS No. 157, paragraph 19 of SFAS No. 115, and Appendix Afor more

information.

2We exclude restricted assets, pension assets, and deferred executive compensation since they

can be viewed as operating assets invested in a particular project or labor payments. We also

exclude derivative hedging, which is studied extensively in a separate literature (e.g., Guay and

Kothari (2003) and Jin and Jorion (2006)).

Precautionary Savings with Risky Assets 795

illiquidity: time deposits, bank deposits, money market funds, commercial pa-

per, and U.S. Treasury securities.

Toassess the motivations and optimality of this behavior, we present a formal

model of a firm’s demand for risky or illiquid financial assets. The model is

a parsimonious representation of a dynamic problem in which the firm has

both present and future real investment projects, and in which the firm has

limited access to external finance. The model can be viewed as an extension of

standard cash models such as Almeida, Campello, and Weisbach (2004). The

main innovation in the model is allowing firms to invest in an array of financial

assets, which include liquid and illiquid assets as well as safe and risky assets.

The model delivers several predictions. First, investing in illiquid or risky

financial assets is suboptimal for financially constrained firms. Second, finan-

cially unconstrained firms benefit from having access to illiquid financial assets

and are at best indifferent to investing in risky financial assets. Importantly,

firms become increasingly indifferent to investing in risky assets as their fi-

nancial portfolios grow. Consequently, firms with larger portfolios invest more

in risky assets and exhibit higher variation in their portfolio allocations. Third,

an additional layer of agency problems or managerial overconfidence may tilt

firms toward investing more in risky financial assets. Fourth, there are no

uniform tax incentives to invest in risky financial assets.

Our empirical findings are consistent with the predictions of our theory. We

find that both risky and illiquid financial asset holdings increase substantially

as the firm becomes more financially unconstrained and holds a larger finan-

cial asset portfolio. Our univariate estimates indicate that firms in the lowest

portfolio size quintile invest 10% of their portfolio in risky securities, whereas

firms in the top quintile invest 40% of their portfolio in risky securities. Fur-

ther, the variation in portfolio allocation within the top size quintiles is also

significantly higher.

We find similar results in multivariate regressions. To mitigate endogene-

ity concerns about the joint determination of the size and composition of the

financial asset portfolio, we provide estimates from a two-stage least squares

(2SLS) model, which exploits unexpected operating cash flow innovations. Our

2SLS estimates suggest that an increase of one percentage point in the size of

the asset portfolio leads to an increase of 30 basis points in the portion of the

portfolio invested in risky assets.

Having established the link between the size of the asset portfolio and its

composition, we investigate the effects of additional firm- and manager-level

attributes. Our estimates reveal a number of systematic patterns. First, consis-

tent with Opler et al. (1999) and Bates, Kahle, and Stulz (2009), the size of the

asset portfolio increases in firm-level proxies for the demand for precautionary

savings, such as cash flow volatility, investment opportunities, and firm size.

In contrast, holding constant the size of the asset portfolio, risky financial as-

sets are concentrated in large, low cash-flow volatility firms, with only average

investment opportunities. These findings are consistent with the prediction

that more financially constrained firms, with a stronger precautionary savings

motive, will avoid risky financial assets.