Hedging, liquidity, and the competitive firm under price uncertainty

Abstract

In this paper, the behavior of the competitive firm under price uncertainty when the firm has access to an intertemporally unbiased futures market is examined. Futures contracts are marked-to-market and thus require interim cash settlement of gains and losses. The firm is subject to a liquidity constraint in that it is forced to prematurely close its futures positionon which the interim loss incurred exceeds a threshold level. It is shown that the liquidity constrained firm optimally opts for an under-hedge should it be prudent. Furthermore, the prudent firm cuts down its optimal level of output in response to the presence of the liquidity constraint. As such, the liquidity risk created by the interim funding requirement of a futures hedge adversely affects the hedging and production decisions of the competitive firm under price uncertainty. © 2004 Wiley Periodicals, Inc.