Discussion paper

DP4755 Liquidity Risk and Corporate Demand for Hedging and Insurance

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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Citation

Rochet, J and S Villeneuve (2004), ‘DP4755 Liquidity Risk and Corporate Demand for Hedging and Insurance‘, CEPR Discussion Paper No. 4755. CEPR Press, Paris & London. https://cepr.org/publications/dp4755