DP4755 Liquidity Risk and Corporate Demand for Hedging and Insurance

Author(s): Jean-Charles Rochet, St├ęphane Villeneuve
Publication Date: November 2004
Keyword(s): corporate hedging, liquidity risk, risk management
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4755

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.