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Title: Liquidity Risk and Corporate Demand for Hedging and Insurance

Author(s): Jean-Charles Rochet and Stéphane Villeneuve

Publication Date: November 2004

Keyword(s): corporate hedging, liquidity risk and risk management

Programme Area(s): Financial Economics

Abstract: We analyse the demand for hedging and insurance by a firm that faces liquidity risk. The firm's optimal liquidity management policy consists of accumulating reserves up to a threshold and distributing dividends to its shareholders whenever its reserves exceed this threshold. We study how this liquidity management policy interacts with two types of risk: a Brownian risk that can be hedged through a financial derivative, and a Poisson risk that can be insured by an insurance contract. We find that the patterns of insurance and hedging decisions as a function of liquidity are poles apart: cash-poor firms should hedge but not insure, whereas the opposite is true for cash-rich firms. We also find non-monotonic effects of profitability and leverage. This may explain the mixed findings of empirical studies on corporate demand for hedging and insurance.

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Bibliographic Reference

Rochet, J and Villeneuve, S. 2004. 'Liquidity Risk and Corporate Demand for Hedging and Insurance'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=4755