Our model shows that deterioration in debt market liquidity leads to an increase in not only the liquidity premium of corporate bonds but also credit risk. The latter effect originates from firms ’ debt rollover. When liquidity deterioration causes a firm to suffer losses in rolling over its maturing debt, equity holders bear the losses while maturing debt holders are paid in full. This conflict leads the firm to default at a higher fundamental threshold. Our model demonstrates an intricate interaction between the liquidity premium and default premium and highlights the role of short-term debt in exacerbating rollover risk. THE YIELD SPREAD OF a firm’s bond relative to the risk-free interest rate directly determines the firm’s debt financing cost, and is often referred to as its credit spread. It is widely recognized that the credit spread reflects not only a default premium determined by the firm’s credit risk but also a liquidity premium due to illiquidity of the secondary debt market (e.g., Longstaff, Mithal, and Neis (2005) and Chen, Lesmond, and Wei (2007)). However, academics and policy makers tend to treat both the default premium and the liquidity premium as independent, and thus ignore interactions between them. The financial crisis of 2007 to 2008 demonstrates the importance of such an interaction— deterioration in debt market liquidity caused severe financing difficulties for many financial firms, which in turn exacerbated their credit risk. In this paper, we develop a theoretical model to analyze the interaction between debt market liquidity and credit risk through so-called rollover risk: when debt market liquidity deteriorates, firms face rollover losses from issuing new bonds to replace maturing bonds. To avoid default, equity holders need to bear the rollover losses, while maturing debt holders are paid in full. This

Firms face uncertain financing conditions and in particular the risk of a sudden rise in financing costs during financial crises. We capture the firm’s precautionary and market timing motives in a tractable model of dynamic corporate financial management when external financing conditions are stochastic. While firms value financial slack and build cash reserves to mitigate financial constraints, uncertainty about future financing opportunities induce them to rationally time the equity market. The market timing motive can cause investment to be decreasing (and the marginal value of cash to be increasing) in financial slack, and can lead a financially constrained firm to gamble. Quantitatively, we find that firms ’ optimal responses to the threat of a financial crisis can significantly smooth out the impact of financing shocks on investments, marginal values of cash, and the risk premium over time. As a result, financially constrained firms might appear to be unconstrained even though the level of their investments has dropped significantly in response to the threat of the crisis. Finally, we highlight the differences in how firms respond to financing shocks and productivity shocks.

Bank of Canada working papers are theoretical or empirical works-in-progress on subjects in economics and finance. The views expressed in this paper are those of the authors. No responsibility for them should be attributed to the Bank of Canada. 2

Abstract! Ensuring that a firm has sufficient liquidity to finance valuable projects that occur in the future is at the heart of the practice of financial management. Yet, while discussion of these issues goes back at least to Keynes (1936), a substantial literature on the ways in which firms manage liquidity has developed only recently. We argue that many of the key issues in liquidity management can be understood through the lens of a framework in which firms face financial constraints and wish to ensure efficient investment in the future. We present such a model and use it to survey many of the empirical findings on liquidity management. Much of the variation in the quantity of liquidity can be explained by the precautionary demand for liquidity. While there are alternatives to cash holdings such as hedging or lines of credit, cash remains “king”, in that it still is the predominate way in which firms ensure future liquidity for future investments. We discuss theories on the choice of liquidity measures and related empirical evidence. In addition, we discuss agency-based theories of liquidity, the real effects of liquidity choices, and the impact of the 2008-9 Financial Crisis on firms ’ liquidity management.

The debt maturity of U.S. industrial firms decreased over the past three decades. This decrease in maturity is driven by the smallest firms for which the median percentage of long-term debt has decreased from 53 % in 1976 to 6 % in 2008. For large firms, however, debt maturity has not declined. Information asymmetry plays an important role in explaining the decrease in debt maturity, while debt and managerial agency problems do not seem to contribute to the decrease. More interesting, we show that firms are using more short-term debt regardless of their characteristics. This unexpected component of debt maturity is more important than changing firm characteristics in explaining the decline in debt maturity and is a result of the new firms issuing public equity in the 1980s and 1990s. Our findings suggest that the shortening of debt maturity has increased the exposure of firms to credit and liquidity shocks. JEL Classification: G30; G32

This paper identifies the interaction between corporate hedging and liquidity policies as an important mechanism through which hedging affects corporate financing and firm value. To motivate our empirical investigation, we present a theoretical model that shows how corporate hedging facilitates greater reliance on cost-effective, externally-provided liquidity in lieu of costly internal resources. We then test our predictions by employing a new empirical approach that separates cash flow hedging from fair value hedging. Using detailed, hand-collected data on corporate hedging, we construct instruments to show that cash flow hedging reduces the firm’s precautionary demand for cash and allows it to rely relatively more on bank lines of credit. Furthermore, we find a significant positive effect of cash flow hedging on firm value. Overall, our results identify a new mechanism through which hedging affects corporate financial policies and firm value.

The introduction of credit default swaps (CDS) trading on an underlying firm may influence its future access to external financing and, hence, its precautionary demand for cash. In this paper, we empirically estimate this effect of CDS trading, using a comprehensive sample of North American corporate CDS introductions between 1997 and 2009. We show that corporate cash holdings, as a proportion of assets, increase after the inception of CDS trading. This impact is significant, even after controlling for the potential endogeneity of CDS trading. We also find that the increase in the cash-to-assets ratio is greater for firms with relatively large amounts of CDS contracts outstanding, and those with more limited access to financial markets. Moreover, the impact of CDS trading goes beyond the direct effects of bank lines of credit, which are generally less reliable sources of finance.

Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may be saved and copied for your personal and scholarly purposes. You are not to copy documents for public or commercial purposes, to exhibit the documents publicly, to make them publicly available on the internet, or to distribute or otherwise use the documents in public. If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. www.econstor.eu

Abstract not found

présentée%et%soutenue%publiquement%le%25%juin%2014% en%vue%de%l’obtention%du% DOCTORAT%EN%SCIENCES%DE%GESTION% Par%