Optimal Hedging in Financially Constrained Firms When Asset Markets Are Illiquid

44 Pages Posted: 19 Oct 2015 Last revised: 29 Nov 2015

See all articles by Håkan Jankensgård

Håkan Jankensgård

Lund University - Department of Business Administration; Knut Wicksell Centre for Financial Studies

Björn Hagströmer

Stockholm University - Stockholm Business School

Date Written: October 19, 2015

Abstract

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

Jankensgård, Håkan and Hagströmer, Björn, Optimal Hedging in Financially Constrained Firms When Asset Markets Are Illiquid (October 19, 2015). Available at SSRN: https://ssrn.com/abstract=2675941 or http://dx.doi.org/10.2139/ssrn.2675941

Håkan Jankensgård (Contact Author)

Lund University - Department of Business Administration ( email )

Box 117
SE-221 00 Lund, S-220 07
Sweden

Knut Wicksell Centre for Financial Studies ( email )

Box 7080
Lund, SE-220 07
Sweden

Björn Hagströmer

Stockholm University - Stockholm Business School ( email )

Stockholm
Sweden

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