Cash Flow Risk Research Articles

Bond risk, bond return volatility, and the term structure of interest rates

Abstract This paper explores the time variation in the bond risk, as measured by the covariation of bond returns with stock returns and consumption growth, and in the volatility of bond returns. A robust stylized fact in empirical finance is that the spread between the yields on long- and short-term bonds forecasts future excess returns on bonds at varying horizons positively; in addition, the short-term nominal interest rate forecasts both the stock return volatility and the exchange rate volatility positively. This paper presents evidence that movements in both the short-term nominal interest rate and the yield spread are positively related to changes in the subsequent realized bond risk and bond return volatility. The yield spread appears to proxy for business conditions, while the short rate appears to proxy for inflation and economic uncertainty. A decomposition of bond betas into a real cash flow risk component and a discount rate risk component shows that yield spreads have offsetting effects in each component. A widening yield spread is correlated with a reduced cash-flow (or inflationary) risk for bonds, but it is also correlated with a larger discount rate risk for bonds. The short rate only forecasts the discount rate component of the bond beta.

Creditor rights and corporate risk-taking

We propose that stronger creditor rights in bankruptcy affect corporate investment choice by reducing corporate risk-taking. In cross-country analysis, we find that stronger creditor rights induce greater propensity of firms to engage in diversifying acquisitions that are value-reducing, to acquire targets whose assets have high recovery value in default, and to lower cash-flow risk. Also, corporate leverage declines when creditor rights are stronger. These relations are usually strongest in countries where management is dismissed in reorganization and are also observed over time following changes in creditor rights. Our results thus identify a potentially adverse consequence of strong creditor rights.

Portfolio Cash Assessment Using Fuzzy Systems Theory

Gaps between cash outflows and inflows throughout the life cycle of construction projects can create extended periods of low cash availability for a construction contractor, jeopardizing the financial stability of the business. A number of researchers have therefore attempted to model cash availability at a project level. However, at a firm level, financial stability is more thoroughly examined as a function of the cash flows related to multiple projects. This paper proposes a methodology on the basis of fuzzy systems theory to forecast cash requirements of a portfolio of projects for a construction firm, taking into account the effect of changing portfolio composition on portfolio cash-flow risk. Portfolio cash-flow risk is calculated from a variance matrix created by using covariance among cash flows of pairs of projects. Expert opinions of a group of highway construction contractors regarding project selection, project risk assessment and cash control were collected to create a fuzzy proportional deriv...

Operational causes of bankruptcy propagation in supply chain

With the increasing interdependence among supply chain members, bankruptcy of a supply chain member may be caused by operational decisions of other members. To investigate how bankruptcy occurs and propagates in supply chain networks, we build a multi-agent simulation model for a two-stage supply chain that consists of multiple upstream manufacturers and multiple downstream retailers. Based on the developed simulation model, we study impacts of various operational parameters and decisions, such as horizontal competition among retailers, order allocation strategies of retailers, wholesale price of manufacturers, characteristics of market demand and number of retailers, on bankruptcy propagation. Since many operational decisions of a firm are made under financial constraints, we also investigate the linkage between firm's operational risks and financial decisions (e.g., the maximal risk of cash flow that a member is willing to take, and the up-front payment proportion of retailers in a two-period payment policy). Experimental results reveal that operational interactions between supply chain members and operational decisions made by supply chain members are important causes of bankruptcy propagation, but impacts of these operational parameters and decisions depend on financial decisions. These observations indicate that supply chain members can moderately hedge their operational risk through financial decisions.

Interactions between Free Cash Flow, Debt Policy and Structure of Governance: 3SLS Simultaneous Model

This research tests the efficiency of the ownership structure and the debt policy as mechanism of resolution of agency conflicts between shareholders and managers du to the problem of overinvestment, in the limitation of the problem of the free cash flow. by estimating three stage least square simultaneous model and on the basis of a sample of 35 non financial Tunisian listed companies selected for the period 1999–2008, our results are in favor of the theory of free cash flows of Jensen (1986) that stipulates that the debt policy represents the principal governance mechanism that can limit the risk of free cash flow. However, the ownership concentration and managerial ownership increase the risk of the free cash flow.  

Capital Structure, Product Market Dynamics, and the Boundaries of the Firm

We study how interactions between financing and investment decisions can shape firm boundaries in dynamic product markets. In particular, we model a new product market opportunity as a growth option and ask whether it is best exploited by a large incumbent firm (Integration) or by a separate, specialized firm (Non-Integration). Starting from a standard theoretical framework, in which value-maximizing corporate investment and financing decisions are jointly determined, we show that Integration best protects assets in place value, while Non-Integration best protects the value of the growth option and maximizes financial flexibility. These forces drive different organizational equilibria depending on firm and product market characteristics. In particular, we show that increases in standard measures of cash flow risk predict exploitation of new opportunities by specialized firms, while increases in product market risk (i.e., the risk of preemption by competitors) predict exploitation by incumbents. We also show that alliances organized as licensing agreements or revenue sharing contracts sometimes better balance the different sources of value, and thus may dominate more traditional forms of organization. These key results arise from the dynamic interaction of the new opportunity’s option-like features with realistic competitive forces.The appendices for this paper are available at the following URL: http://ssrn.com/abstract=2443868

Estimating Cashflow-at-Risk (CFaR)

Of the many risks faced by restaurants, a shortage of cashflow is among the most damaging. This study introduces an effective tool to estimate the cashflow risk of restaurants, so that firms can be ready to address the potential risks. Using a comparables approach to Cashflow-at-Risk (CFaR), the study analyzes cashflow data from publicly listed U.S. restaurant firms from 1988 to 2007. The study found that estimated cashflow shortfalls were larger for small and medium-size firms than for large firms. Also, full-service restaurants’ cashflow shortfalls were larger than those of limited-service restaurants, suggesting relative cashflow risk positions for different restaurant segments. This study provides nonfinancial firms such as restaurant firms with a practical tool to estimate cashflow risk, which could mitigate the probability of financial distress and improve the financial health of firms.

New estimates of the cost of capital for pharmaceutical firms

Academic researchers, as well as pharmaceutical firms themselves, often use the Capital Asset Pricing Model (CAPM) to estimate a firm's cost of capital. But the CAPM implicitly assumes that cash flows follow a random walk. This assumption is inconsistent with our finding that large U.S.-based pharmaceutical firms' cash flow growth rates display either momentum or mean-reversion. We show that growth rate momentum implies: (1) the systematic risk of a project increases monotonically with time to maturity of the cash flows; and (2) longer duration projects require a higher cost of capital. One of the practical implications of our results is that the traditional CAPM underestimates the cost of capital for some pharmaceutical firms by as much as 2.8%. These findings are quite relevant for the policy debate about the high rates of return earned by pharmaceutical companies, which some claim are pure rents and are not necessary to attract investors. Our theoretical and empirical analysis shows that high returns are often required to compensate for the higher systematic risk of long-duration pharmaceutical cash flows.

Including Cash Flow Risk In Stock Return Analysis

<p class="MsoBlockText" style="text-align: justify; margin: 0in 0.5in 0pt; mso-pagination: none;"><span style="font-style: normal; color: black; mso-bidi-font-style: italic; mso-bidi-font-size: 10.0pt;"><span style="font-size: x-small;"><span style="font-family: Times New Roman;">Despite their prominence in financial theory and practice, the Capital Asset Pricing Model and its critical beta component have failed test after test to explain stock returns.<span style="mso-spacerun: yes;">  </span>Research by Campbell and Vuolteenaho cites the misspecification of beta as the reason for this failure.<span style="mso-spacerun: yes;">  </span>They measure beta as the sum of two components: a more influential “cash-flow” beta and a secondary “discount-rate” beta.<span style="mso-spacerun: yes;">  </span>The current study creates a ratio between the overall beta of a stock and the cash-flow component and uses an ordinary least squares regression model to determine its significance in interpreting overall returns to a stock, hypothesizing that the ratio will better explain returns than the overall beta alone.<span style="mso-spacerun: yes;">  </span>The results are mixed but suggest significant explanatory power for the beta range of 0.60 to 0.95.</span></span></span></p>

Liquidity management and corporate demand for hedging and insurance

Abstract We analyze the demand for hedging and insurance by a firm facing cash-flow risks. We study how the firm’s liquidity management policy interacts with two types of risk: a Brownian risk that can be hedged through a financial derivative, and a Poisson risk that can be insured by an insurance contract. We find that the patterns of insurance and hedging decisions are pole apart: cash-poor firms should hedge but not insure, whereas the opposite is true for cash-rich firms. We also find non-monotonic effects of profitability. This may explain the mixed findings of empirical studies on corporate demand for hedging and insurance.

The cross-section of equity returns and assets’ fundamental cash-flow risk

The decomposition of consumption beta into a component driven by assets’ cash-flow news and one related to assets’ discount-rate news reveals that macroeconomic risks embodied in cash flows largely account for the cross-sectional dynamics of average stock returns. Empirically, we find that differences in expected excess returns between low book-to-market and high book-to-market portfolios are associated with differences in their cash-flow betas, and thus reflect macroeconomic, especially consumption-related risks. This result holds true for a broad set of consumption-based asset pricing models. In addition, the results indicate that the risk premium on equity markets is primarily driven by the exposure of assets’ cash-flow components to the cyclical variability of durable consumption goods.

On delineating supply chain cash flow under collectionrisk

The credit terms for accounts receivable (AR) offered by sellers to buyers not only create a time lag between supply chain physical flow and cash flow, but also increase the collection risk contributed by late collection and default. Previous studies describing the relationship between the two major supply chain flows did not consider the collection risk, which poses a serious challenge to companies with limited cash resources when seeking growth opportunities in sales. This study first delineates the relationship between the two flows during a growth period without imposing any constraints. A stochastic optimization model is then developed to observe the managerial implications of cash flow risk under tight cash constraints.

Chilean Stock Market Expected Return Analysis: A Variance Decomposition

The main objective of this paper is to quantify the effect of expectation changes about discount rate and dividend growth rate over the Chilean market portfolio returns. The model applied was taken from the works of Campbell and Shiller (1988, 1988a), Campbell (1991) and Campbell and Vuolteenaho (2005). The model expresses the unexpected returns as a function of two components related with: (i). news about future dividends growth and (ii). news about future returns of the market portfolio. The results obtained for the period of 1995-2005 show that the component of news about future dividends explains most of the unexpected portfolio returns variance, contrary to Campbell and Vuolteenaho (2005) find in the US data. Indeed, the differences are explained by the lower persistence observed in the variables utilized in estimates; thus, the long term return forecasting is less acute, which augments the estimation errors and finally, the news about dividends growth importance. Considering some feature of the Chilean stock market such as legal, tax, ownership concentration and information quality, news about future returns should not be as important as in the US stock market. The model also allows to divide, the traditional beta of the Capital Asset Pricing Model (CAPM) in two components, i.e.: (i). a component related with the future cash flows and (ii). a component which reflect the relationship between the stock returns with the discount rates of the market portfolio. The results show that the high return observed in the small-value stocks, it due to their beta is predominated for the cash flow risk component. Thus, the adjustment obtained when beta is separating in these components improves relatively with those resulted from the traditional method. Unlike US, in Chile have not been developed a formal methodology that quantifies the incidence of changes in expectations of discount rates and dividends over stock prices. Additionally, this work is the first in applying an approach of decomposition of the systematic risk in Chilean data.

What's Vol Got to Do with It

Uncertainty plays a key role in economics, finance, and decision sciences. Financial markets, in particular derivative markets, provide fertile ground for understanding how perceptions of economic uncertainty and cash-flow risk manifest themselves in asset prices. We demonstrate that the variance premium, defined as the difference between the squared VIX index and expected realized variance, captures attitudes toward uncertainty. We show conditions under which the variance premium displays significant time variation and return predictability. A calibrated, generalized long-run risks model generates a variance premium with time variation and return predictability that is consistent with the data, while simultaneously matching the levels and volatilities of the market return and risk-free rate. Our evidence indicates an important role for transient non-Gaussian shocks to fundamentals that affect agents' views of economic uncertainty and prices. The Author 2010. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.

Habit formation, the cross section of stock returns and the cash-flow risk puzzle

Non-linear external habit persistence models, which feature prominently in the recent “equity premium” asset pricing and macroeconomics literature, generate counterfactual predictions in the cross-section of stock returns. In particular, we show that in the absence of cross-sectional heterogeneity in firms’ cash-flow risk, these models produce a “growth premium,” that is, stocks with high price-to-fundamental ratios command a higher premium than stocks with low price-to-fundamental ratios. This implication is at odds with the well-established empirical observation of a “value premium” in the cross-section of stock returns. Substantial heterogeneity in firms’ cash-flow risk yields both a value premium as well as most of the stylized facts about the cross-section of stock returns, but it generates a “cash-flow risk puzzle”: Quantitatively, value stocks have to have “too much” cash-flow risk compared to the data to generate empirically plausible value premiums.

Long Run Risk, the Wealth-Consumption Ratio, and the Temporal Pricing of Risk

Representative agent consumption based asset pricing models have made great strides in accounting for many important features of asset returns. The long run risk (LRR) models of Ravi Bansal and Amir Yaron (2004) are a prime example of this progress. Yet, several other representative agent models, such as the external habit model of John Y. Campbell and John H. Cochrane (1999) and the variable rare disasters model of Xavier Gabaix (2008), seem to be able to match a similar set of asset pricing moments. Additional moments would be useful to help distinguish between these models. Hanno Lustig, Stijn Van Nieuwerburgh, and Adrien Verdelhan (2009) argue that the wealth-consumption ratio is such a moment. A comparison of the wealthconsumption ratio in the LRR model and in the data is favorable to the LRR model. This is no small feat because the wealth-consumption ratio is not a target in the usual calibrations of the model, and the LRR is—so far—the sole model able to reproduce both the equity premium and the wealth-consumption ratio. The LRR model matches the properties of the wealth-consumption ratio despite the fact that it implies a negative real bond risk premium. This is because it generates quite a bit of consumption cash flow risk to offset the negative discount rate risk. Long Run Risk, the Wealth-Consumption Ratio, and the Temporal Pricing of Risk

Investment Irreversibility, Cash Flow Risk, and Value‐Growth Stock Return Effects

AbstractWe simulate results from a simple real options model to provide insight into the value‐growth stock return anomaly. In our model, firms possess either single (“value” firm) or multiple (“growth” firm) investment opportunities. Our model predicts that growth firms: (1) invest sooner, (2) exhibit greater continuity in capital expenditure over time, (3) have lower book‐to‐market ratios, and (4) generate lower rates of return than value firms.

The Public Private Partnership Paradox

A public private partnership (PPP) is a contractual arrangement between government and the private sector, usually for the delivery of a piece of social infrastructure or a social service. Over the past 10 years, PPP activity around the globe amounts to many billions of dollars. The key features of a PPP arrangement are (a) that government will make a series of cash payments to the private sector, usually over a long “concession” period in excess of 20 years; and (b) that the risk (particularly the systematic risk) of the project is shared between the government and private sector. Governments must determine whether the payments to be made under the PPP (given their amount and risk) represent value for money relative to the cash flows (and risk) that would be involved with traditional or alternative government procurement options. The standard valuation framework based on the Capital Asset Pricing Model (CAPM) suggests that alternative streams of cash flows should be discounted to present value at a rate reflecting their systematic risk. In the context of PPPs, it has been argued that the standard framework produces a paradox whereby government appears to be made better off by taking on more systematic risk. This has led to a range of approaches being applied in practice, none of which are consistent with the standard CAPM valuation approach. In this paper, we demonstrate that the proposed approaches suffer from internal inconsistencies and produce illogical outcomes in some cases. We also show that there is no problem with current accepted theory, and that the apparent paradox is not the result of a deficiency in the current theory, but rather is caused by its misapplication in practice. In particular, we show that the systematic risk of cash flows is frequently mis-estimated, and the correction of this error solves the apparent paradox. In this regard, we show that our results are consistent with the substantial 1970s and 1980s literature on the discounting of cash outflows – a literature that was apparently ignored when PPP evaluation frameworks were developed.

The Cross-Section of Expected Stock Returns: Learning about Distress and Predictability in Heterogeneous Orchards

We study an equilibrium asset pricing model with several Lucas (1978) trees subject to persistent distress events, where the agent has incomplete information about the state of an underlying common factor and learns from the events occurring to each tree. Contrary to similar asset pricing models with learning in one-tree economies, we find that cross-sectional learning and distress events can reverse several implications and help to explain empirical equity premia and risk-free rate dynamics. We also find that learning helps to generate more realistic dispersion of cross-sectional expected returns, relative to pure aggregate consumption risk models with complete information and disaster risk. The model provides a simple setting to study the asset pricing implications of orchards in which the cash flow links among different trees are asymmetric and some trees are more exogeneous than others. This allows, among other things, to link reduced-form assumptions of cash-flow risk heterogeneity to the structural properties of the orchard. Finally, we show that the cash-flow connectivity of a firm in the orchard is linked to the slope of the dividend strip curve. Sectors whose dividend process is exogenous in the orchard have negatively sloped term structures of dividend swaps. The opposite holds for endogenous sectors.

Long Run and the Temporal Aggregation of Risks

The long-run risk model introduced by R.Bansal and A.Yaron (2004) assumes the existence of a small predictable component in consumption growth and an elasticity of intertemporal substitution of the representative agent larger than one for the substitution effect to dominate the income one. Previous tests fail to detect predictability in mean consumption growth fluctuations and the estimated value for the elasticity of intertemporal substitution is smaller than one. We argue that these apparent inconsistencies are due to a severe error-in-variables problem generated by the heterogeneity in the persistence levels of shocks to consumption growth. In this paper the original long run risk model is extended introducing a novel persistence based decomposition which can be considered as a refined permanent-transitory decomposition where the transitory shock is further split into orthogonal components. This new decomposition provides an effective method to represent a time series as a linear combination of innovations classified by their level of persistence and their time of arrival. Correspondingly the relations between equity return variations, cash flow risk and persistent fluctuations in the consumption mean are disaggregated across different levels of persistence and the complete term structure of risk return tradeoffs is computed. Quite remarkably, the empirical tests performed within this extended setup find evidence of consumption growth predictability, produce sizeable estimated for the equity premia and explain the value premium as an effect of the differential exposure of cash flows to consumption risk.