Understanding Cash Flow Risk

Theory has recently shown that cash flow risk depends on the exposure of firms to short- and long-term cash flow shocks and the correlation between these shocks, with a higher correlation reducing risk. We provide granular estimates of these parameters for Compustat firms using a new filter that uses only cash flow data and the theoretical restrictions imposed by a canonical cash flow model. We show empirically that the estimated parameters have first-order effects on firms’ policies, that firms with a higher estimated correlation between shocks implement riskier policies, and that the sign of this correlation determines that cash flow sensitivity of cash as predicted by theory.