Liquidity Risk and Corporate Demand for Hedging and Insurance

Jean Rochet and Stephane Villeneuve

No 4755, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We analyse 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 (search for similar items in EconPapers)
Date: 2004-11
New Economics Papers: this item is included in nep-fin and nep-ias
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Citations: View citations in EconPapers (14)

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