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Do investors infer future cash flow volatility based on liquidity?

Author

Listed:
  • Ben Angelo

    (Ball State University)

  • Mitchell Johnston

    (University of Dayton)

Abstract

Prior literature has studied the relationship between historic cash flow volatility and current levels of liquidity (Bates et al. in J Financ 64:1985–2021, 2009; Han and Qiu in J Corp Financ 13:43–57, 2007). In this paper, we study the relationship between liquidity and future returns. When investors observe a highly liquid balance sheet, they infer the firm’s beliefs about the risk of future cash flow volatility and price the stock accordingly. Our measure of liquidity is negatively and significantly associated with subsequent period stock returns. More liquid firms earn significantly higher levels of returns over the subsequent period, consistent with investor perceptions that liquidity is positively associated with future cash flow risk. We also find that firms with highly liquid balance sheets also realize significantly higher levels of future cash flow volatility, consistent with precautionary savings. This represents one possible explanation for why investors perceive more liquid firms as riskier than their less liquid counterparts.

Suggested Citation

  • Ben Angelo & Mitchell Johnston, 2023. "Do investors infer future cash flow volatility based on liquidity?," Review of Quantitative Finance and Accounting, Springer, vol. 60(1), pages 259-294, January.
    • Handle: RePEc:kap:rqfnac:v:60:y:2023:i:1:d:10.1007_s11156-022-01094-4
    DOI: 10.1007/s11156-022-01094-4
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    References listed on IDEAS

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    More about this item

    Keywords

    Asset liquidity; Balance sheet asset liquidity; Cash flow volatility; Precautionary savings;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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