Risk Management with Options and Futures under Liquidity Risk
Journal of Futures Markets, Forthcoming
Posted: 18 Aug 2008
Futures hedging creates liquidity risk through marking to market. Liquidity risk matters if interim losses on a futures position have to be financed at a markup over the risk-free rate. This paper analyzes the optimal risk management and production decisions of a firm facing joint price and liquidity risk. It provides a rationale for the use options on futures in imperfect capital markets. If liquidity risk materializes, the firm sells options on futures in order to partly cover this liquidity need. It is shown that liquidity risk reduces the optimal hedge ratio and that options are not normally used before a liquidity need actually arises.
Keywords: liquidity risk, risk management, options on futures, futures
JEL Classification: G11, D81
Suggested Citation: Suggested Citation