Academic journal article International Advances in Economic Research

Liquidity, Investment and Risky Debt: Some Evidence

Academic journal article International Advances in Economic Research

Liquidity, Investment and Risky Debt: Some Evidence

Article excerpt

Utilizing bond data for U.S. non-financial corporations, this study finds a relationship between liquid assets and default premia. The paper argues that this can be explained by endogenous adjustments in liquid asset holdings by firms concerned with the possibility of a liquidity shortage, which, in the presence of external financing constraints, may trigger default and the costs of financial distress. As a result, riskier firms have not only higher default premia, but also larger holdings of liquid assets. Thus, the endogeneity of liquidity may be central to the interaction between default risk and the condition of the firm's balance sheet. Simple regressions that treat liquidity as an exogenous parameter may therefore yield unreliable results.

In our model, a positive relationship arises when future firm cash flows cannot be fully pledged as collateral for borrowing and the benefits of firm investment can only be realized if the firm does not default. At the same time, exogenous changes in the firm's liquidity are expected to be negatively related to default premia. The prior expectation that firms with high liquidity should be safer explains the direct effect of liquidity on default premia, but does not capture the indirect effect arising from the endogeneity of liquidity, which appears to dominate in practice.

Previous studies have focused on leverage and volatility as determinants of default premia, and ignore the potential effect of liquidity. …

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