Three essays on corporate cash policy and financial markets

Abstract

This dissertation includes three research papers, two of which are empirical studies and one of which illustrates a mechanism through a theoretical model. The first paper focuses on the effect of stock market liquidity on corporate cash holdings. This paper provides empirical evidence that stock market liquidity has a positive impact on cash holdings. The two main competing hypotheses are cascade hypothesis and financial constraints hypothesis. Subrahmanyam and Titman (2001) study the cascade mechanism through which stock prices affect cash flows. In this paper, the cascade hypothesis states that firms with more liquid stocks need more cash holdings to avoid negative cascades or to stimulate positive cascades, whereas the financial constraints hypothesis states that firms with more liquid stocks need less cash holdings because more liquid stocks indicate less cost of external financing and then less financial constraints. The empirical findings support the cascade hypothesis. Causality is carefully tested through a decimalization test, which is designed based on the tick decimalization in stock markets in 2001. Furthermore, a test by a system of simultaneous equations suggests that there is a two-way causality between stock market liquidity and cash holdings. The second paper studies the causal impact of stock short sales on corporate cash holdings. Short sellers benefit from the drop of stock prices, which provides strong incentive to dig on the dark side of firms. For example, short sellers actively investigate target firms and aggressively spread negative research reports among stakeholders (e.g. capital providers, customers, suppliers, and employees). Short sales facilitate the incorporation of negative information into stock prices. Attacks of short sellers isolate firms from stakeholders, increase the cost of external financing, and decrease operational cash flow. Firms should be wary of short selling activities in financial markets. Precautionary motive drives the firms hold cash as the ammunition for the battle with short sellers and as unconditional liquidity support during negative events. This paper provides empirical evidence that short-selling pressure has a positive impact on cash holdings. The results are robust after controlling for relevant firm characteristics, heterogeneity of belief, investors' holding horizons, institutional monitoring incentives, and other information channels (such as financial analysts). A test by a system of simultaneous equations supports the causal impact of short sales on cash holdings and excludes the reverse causality. This paper also sheds light on a better understanding of the determinants of short-selling activities in financial markets. The third paper proposes a theoretical model to demonstrate a mechanism by which financial markets affect corporate policies when managers do not learn from financial markets. The existing research on the real effect of financial markets on corporate policies depends on the assumption that corporate managers learn from prices in financial markets when making corporate policies (Chen, Goldstein and Jiang, 2007; Bond, Goldstein and Prescott, 2010; Edmans, Goldstein, and Jiang, 2012; Fresard, 2012). The manager-learning argument is reasonable and intuitive. However, given the fact that managers naturally have an informational advantage with regard to the firms they operate, will financial markets affect corporate policies if managers do not need to learn from financial markets? This paper suggests a channel based on the interaction between managers and other stakeholders. This paper extends the idea in Subruhmanyam and Titman (2001) by considering financial constraints of the new investment and adding a firm manager in the model structure. The manager has private information and does not need to learn from financial market. However, other stakeholders, such as customers, suppliers, capital providers, may learn from security prices, and their actions affect corporate cash flows and may generate new investment opportunities. Therefore, even if managers do not need to learn from financial markets, they still can not ignore financial markets when making corporate policies.