Liquidity Risk and Corporate Demand for Hedging and Insurance

40 Pages Posted: 8 Feb 2005  

Jean-Charles Rochet

University of Zurich - Swiss Banking Institute (ISB); University of Toulouse I - Institut d'Economie Industrielle (IDEI); Swiss Finance Institute

Stephane Villeneuve

University of Toulouse 1 - Toulouse School of Economics (TSE)

Date Written: November 2004

Abstract

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.

Keywords: Liquidity risk, risk management, corporate hedging

Suggested Citation

Rochet, Jean-Charles and Villeneuve, Stephane, Liquidity Risk and Corporate Demand for Hedging and Insurance (November 2004). CEPR Discussion Paper No. 4755. Available at SSRN: https://ssrn.com/abstract=663403

Jean-Charles Rochet (Contact Author)

University of Zurich - Swiss Banking Institute (ISB) ( email )

Plattenstrasse 14
CH-8032 Zurich, Zurich 8032
Switzerland

University of Toulouse I - Institut d'Economie Industrielle (IDEI) ( email )

Manufacture des Tabacs
21 Allee de Brienne bat. F
Toulouse Cedex, F-31000
France
+33 5 6112 8641 (Phone)
+33 5 6112 8637 (Fax)

Swiss Finance Institute ( email )

c/o University of Geneve
40, Bd du Pont-d'Arve
1211 Geneva, CH-6900
Switzerland

St├ęphane Villeneuve

University of Toulouse 1 - Toulouse School of Economics (TSE) ( email )

Place Anatole-France
Toulouse Cedex, F-31042
France

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