Paper outlines how large cash holdings can lead to mismeasurement of risk

The implications for financial stability and asset prices – including that firms’ large cash holdings can lead to mismeasuring risk – are addressed in a working paper on cash-hedged stock returns, published Tuesday by the federal agency created to study threats and opportunities to financial stability.

According to the Treasury’s Office of Financial Research (OFR), an agency created in the wake of the 2008 financial crisis to keep an eye on threats to the financial system, cash holdings are important for financial stability because of their value in crises. However, the agency said, holding cash comes at a cost: its low pecuniary return. The OFR said the paper shows how investors can hedge cash on firms’ balance sheets when making portfolio choices.

“Cash generates variation in beta estimates, and the working paper decomposes stock betas into components that depend on the firm’s cash holding, return on cash, and cash-hedged return,” OFR said in a statement. “Common asset pricing premia have large implicit cash positions, and portfolios of cash-hedged premia often have higher Sharpe ratios, used by investors to understand a return on investment, because of the correlation between firms’ cash returns.

“The paper shows the value of a dollar increased in 2020, and firms hold cash because they are riskier,” the agency said.

(A Sharpe ratio is defined as a measure that indicates the average return minus the risk-free return divided by the standard deviation of return on an investment.)

Corporate cash piles vary across companies and over time, OFR asserted. “Firms’ cash holdings typically earn low returns, and their cash returns are correlated across firms. Thus, the asset pricing results are important for investors managing a portfolio’s risk and policymakers concerned about sources of vulnerability.”

OFR Finds Large Cash Holdings Can Lead to Mismeasuring Risk