Description:
Corporate cash holdings can predict stock returns, but whether it is a risk or mispricing effect is still unclear. Through constructing a cash factor ‘LMS’, this study explores the mechanisms of cash-returns relationship. We find that although LMS is pervasive and captures co-movement in stock returns, LMS loading cannot predict returns after considering cash characteristic and shows negative associations with implied cost of capital. Also, LMS cannot reflect future gross domestic product (GDP) growth. Our results are not consistent with rational capital asset pricing theories and cast doubts on the risk explanation while supporting a mispricing explanation