Liquidity Risk and Corporate Demand for Hedging and Insurance
University of Zurich - Swiss Banking Institute (ISB); University of Toulouse I - Institut d'Economie Industrielle (IDEI); Ecole Polytechnique Fédérale de Lausanne - Swiss Finance Institute
University of Toulouse 1 - Toulouse School of Economics (TSE)
CEPR Discussion Paper No. 4755
We analyze 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.
Number of Pages in PDF File: 40
Keywords: Liquidity risk, risk management, corporate hedging
Date posted: February 8, 2005
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