40 Pages Posted: 8 Feb 2005
Date Written: November 2004
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: 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
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