Cash Flow Hedging and Liquidity Choices

Using unique, hand-collected data, this paper investigates how corporations combine the use of derivative hedging, cash holdings, and bank lines of credit to manage cash flow risks. Consistent with a precautionary saving motive, we find that (i) cash flow hedging derivatives and/or lines of credit serve as substitutes for cash, and (ii) the sensitivity of cash to cash flow volatility is significantly lower for firms that use either derivative hedging, lines of credit, or both. We highlight an important and largely unexplored interaction between cash flow hedging and the use of credit lines: Hedging pushes firms to substitute cash for lines of credit, since it reduces the risk of violating financial covenants. We also investigate the determinants of cash flow hedging, and find that its usage is concentrated in industries exposed to foreign currency and commodity price risks. This, in turn, implies that a firm's line of business is a significant determinant of its liquidity choice. Overall, our findings shed new light on the joint determination of corporate policies to manage cash flow risks.