Optimal Hedging in Financially Constrained Firms When Asset Markets Are Illiquid
44 Pages Posted: 19 Oct 2015 Last revised: 29 Nov 2015
Date Written: October 19, 2015
Financially constrained firms can use hedging to lower the risk of financial distress. However, spending scarce resources on hedging exacerbates the underinvestment problem of these firms. We develop a model in which this cost of hedging is traded off against a reduction in the risk of being forced to liquidate assets in inefficient markets, which implies having to sell at a discount relative to fair asset value (“the asset illiquidity discount”). We show that the optimal hedge ratio increases with the correlation between the asset illiquidity discount and the hedgeable risk factor. This novel feature has important implications for the relation between the hedgeable risk factor and the cost of liquidity shortfalls. We illustrate our theoretical model using the case of Saga Petroleum, a Norwegian oil exploration firm.
Keywords: Asset illiquidity, financial distress, risk management, hedging, financial constraints
JEL Classification: G30, G32
Suggested Citation: Suggested Citation