The uncertainty of cash flows and the risk of adverse cash flow shocks are central concerns in virtually all corporate finance decisions. When capital markets are not frictionless, insufficient cash flows might force companies to underinvest, cut dividends, or become financially distressed. Therefore, not surprisingly, shareholders and managers tend to be very concerned about the detrimental impact of cash flow risk on firm value.
What can managers do to address cash flow risks? One alternative is to make use of hedging instruments, such as options, futures and swaps. Another is to amass precautionary liquid resources in the form of cash reserves or bank lines of credit. However, these choices are neither independent nor mutually exclusive. In equilibrium, firms choose the optimal mixture of hedging, cash, and lines of credit simultaneously. It is therefore important to study these alternatives together.
The purpose of this paper is twofold. We start by investigating how firms shape their overall hedging and liquidity policies. We then study the choice between the various instruments available to them. To this end, we look at firms’ hedging strategies, cash holdings, and bank lines of credit jointly, and provide a unified empirical investigation of the relationship between the three. Our findings suggest that the decision to use each of these instruments is affected by the use of the others. Firms tend to substitute cash with either cash flow hedging, lines of credit, or both. Furthermore, firms that use cash flow hedging tend to rely more on lines of credit. Due to the joint determination of the hedging and liquidity policies in equilibrium, we also estimate a simultaneous equation model and find consistent results.
We also find that the ability to use cash flow hedging is largely related to the industry: Cash flow hedging is concentrated in industries that are exposed to foreign currency and commodity price risks. One possible explanation is that derivatives are more readily available to hedges these types of risks. Our results also indicate that cash flow hedging makes it easier for companies to use credit lines in lieu of cash because it decreases the likelihood of violating cash-flow based covenants. Taken together, our results highlight the interdependence between cash flow hedging and liquidity choices, and provide a new, more comprehensive look into corporate risk management. Before further developing our argument, we briefly discuss how previous literature studied these three policies in isolation.
Previous literature considered corporate risk management and corporate liquidity policies separately. Theoretical work on risk management emphasizes the importance to hedge against adverse cash flow shocks that might force firms to (i) forgo valuable investment opportunities due to costly external financing, (ii) violate debt covenants or miss principal/coupon payments and suffer deadweight costs, and (iii) lose customers, suppliers and employees. Consistently, the empirical literature on corporate hedging finds that derivatives are associated with a reduction in risk (e.g., Guay (1999), Jin and Jorion (2006), and Bartram, Brown, and Conrad (2008)). The overall effect on firm value is, however, unclear (e.g., Gutay and Kothari (2003), Adam and Fernando (2006), and Bartram, Brown, and Conrad (2008)).
