Liquidity risk and corporate hedging with futures

Abstract

This paper examines the hedging behaviour of a value-maximizing firm that exists for two periods. The firm faces uncertain income and is subject to tax asymmetries with no loss-offset provisions. The firm has access to unbiased futures contracts in each period for hedging purposes. We impose a liquidity constraint on the firm. Specifically, whenever the net interim loss due to its first-period futures position exceeds a predetermined threshold level, the firm is forced to terminate its risk management program and, therefore, is prohibited from trading the futures contracts in the second period. We show that the liquidity-constrained firm optimally adopts a full-hedge via its second-period futures position to minimize the extent of the income risk and an under-hedge via its first-period futures position to limit the degree of the liquidity risk. © 2011 The Authors. Pacific Economic Review© 2011 Blackwell Publishing Asia Pty Ltd.