OFR Working Paper Finds Cash Biases Measurement of the Stock Return Correlations

[from the U.S. Office of Financial Research]

Today, the U.S. Office of Financial Research published a working paper, “Cash-Hedged Stock Returns” [archived PDF], and an accompanying blog (below), regarding firms’ cash holdings and the implications for asset prices and financial stability.

Cash holdings are important for financial stability because of their value in crises.  Corporate cash piles vary across companies and over time. Firms’ cash holdings typically earn low returns, and their cash returns are correlated across firms.  Thus, the asset pricing results are important for investors managing a portfolio’s risk and policymakers concerned about sources of vulnerability.

The working paper [archived PDF] shows how investors can hedge cash on firms’ balance sheets when making portfolio choices.  Cash generates variation in beta estimates, and the working paper decomposes stock betas into components that depend on the firm’s cash holding, return on cash, and cash-hedged return. Common asset pricing premia have large implicit cash positions, and portfolios of cash-hedged premia often have higher Sharpe ratios, used by investors to understand a return on investment, because of the correlation between firms’ cash returns. The paper shows the value of a dollar increased in 2020, and firms hold cash because they are riskier.

Read the working paper [archived PDF].

OFR Finds Large Cash Holdings Can Lead to Mismeasuring Risk

[from the OFR blog, by Sharon Ross]

Cash is necessary for companies’ operations. Firms use cash to make payments, finance investments, and manage risk. But holding cash comes at a cost: its low pecuniary return. Published today by the OFR, the working paper, “Cash-Hedged Stock Returns” [archived PDF], shows that the cash returns of publicly traded, non-financial firms are correlated. Since cash returns are a part of equity returns, investors that are using equity return correlations to measure risk can mismeasure risk.

We show the importance of cash for systemic risk by documenting the value of cash in crises, showing that firms hold cash in part due to risk management and studying how cash biases the measurement of the interconnectedness of stock returns. The consequences of cash are important for policymakers monitoring aggregate risks, and sources of market vulnerability and for investors making portfolio choices.

Cash holdings are important for financial stability because of their value in crises. Several papers document a “dash for cash” during the initial panicked stages of the coronavirus 2019 (COVID-19) pandemic when firms rushed to hold cash in their coffers. The dash for cash was driven by firms drawing down on lines of credit from banks, which in turn affected bank lending. The dash for cash highlighted the critical role of firms’ cash holdings and returns in understanding risk in the financial system.

We show the value of a dollar increased in 2020. Moreover, our results show that firms may hold cash because they are riskier, as opposed to firms with high cash shares being less risky due to their cash holdings. Our results are consistent with a precautionary savings motive for holding cash. In other words, firms hold cash for risk management, in part to weather bad times.

Cash is a growing share of public firmsassets. The value-weighted U.S. stock market held 22% of its assets in cash in December 2020 compared to 8% in the 1980s. An investor buying the market in 2020 ends up with an implicit cash position three times larger than in 1980. Individual firms vary in how much cash they hold. As cash holdings increase, it is important to understand how cash holdings affect returns, which in turn impacts who chooses to invest in the firms.

Cash returns are correlated across firms, and cash biases measurement of the interconnectedness of stock returns, making it a risk for financial stability. As a result, the asset pricing results are important both for investors managing portfolio risk and for policymakers concerned about interconnected returns.

We argue that the value of corporate cash is distinct, and we can separate the value of cash and the value of the firm’s primary business. We show how investors can explicitly account for the effect of corporate cash holdings when forming a portfolio. When an investor owns stock in a company with substantial cash, the investor has an implicit cash position managed by the company—something the investor might not intend. We argue that investors should account for the effect of corporate cash holdings in the portfolio decision to measure a portfolio’s risk. Firms’ cash management is not consistent across firms, and investors may want to manage their cash positions themselves. Policymakers should be aware of investors’ choices in cash because of investorsportfolio risk and the implications for aggregate risk.

We separate a company’s stock return into its cash and non-cash components, and we show that using the non-cash return gives a more informative correlation structure across stocks. In other words, if investors take out the correlated cash returns, the remaining return is less correlated, yielding portfolios that provide better diversification. We show how cash holdings and returns affect the returns of standard asset pricing strategies and asset pricing models like the capital asset pricing model (CAPM).

As cash holdings of public firms increase, it is important that policymakers understand how these increases impact stock returns for both individual firms and the aggregate market. Cash returns are correlated across firms, and cash biases the measurement of the interconnectedness of stock returns. This correlation is important both for investors who are managing a portfolio’s risk and policymakers concerned about sources of vulnerability stemming from interconnected returns.

Essay 96: Education and London’s Centrality in Global Finance: Then and Now

To understand our world, we have to go back to classics of understanding such as Lombard Street [Project Gutenberg ebook] which gives one a vivid sense of London’s rise as world’s banker, already in 1873. 

Our current world was certainly shaped by these long-term historical trends.

…But very few persons are aware how much greater the ready balance—the floating loan-fund which can be lent to any one or for any purpose—is in England than it is anywhere else in the world. A very few figures will show how large the London loan-fund is, and how much greater it is than any other. The known deposits—the deposits of banks which publish their accounts—are, in

London (31st December, 1872). . . . . . . .£120,000,000
Paris (27th February, 1873) . . . . . . . . . .13,000,000
New York (February, 1873) . . . . . . . . . .40,000,000
German Empire (31st January, 1873) . . .8,000,000

And the unknown deposits—the deposits in banks which do not publish their accounts—are in London much greater than those in any other of these cities. The bankers’ deposits of London are many times greater than those of any other city—those of Great Britain many times greater than those of any other country.

Of course the deposits of bankers are not a strictly accurate measure of the resources of a Money Market. On the contrary, much more cash exists out of banks in France and Germany, and in all non-banking countries, than could be found in England or Scotland, where banking is developed. But that cash is not, so to speak, “Money-Market money”: it is not attainable. Nothing but their immense misfortunes, nothing but a vast loan in their own securities, could have extracted the hoards of France from the custody of the French people. The offer of no other securities would have tempted them, for they had confidence in no other securities. For all other purposes the money hoarded was useless and might as well not have been hoarded. But the English money is “borrowable” money. Our people are bolder in dealing with their money than any continental nation, and even if they were not bolder, the mere fact that their money is deposited in a bank makes it far more obtainable. A million in the hands of a single banker is a great power; he can at once lend it where he will, and borrowers can come to him, because they know or believe that he has it. But the same sum scattered in tens and fifties through a whole nation is no power at all: no one knows where to find it or whom to ask for it. Concentration of money in banks, though not the sole cause, is the principal cause which has made the Money Market of England so exceedingly rich, so much beyond that of other countries.

…I believe that our system, though curious and peculiar, may be worked safely; but if we wish so to work it, we must study it. We must not think we have an easy task when we have a difficult task, or that we are living in a natural state when we are really living in an artificial one. Money will not manage itself, and Lombard Street has a great deal of money to manage.