DP4755 Liquidity Risk and Corporate Demand for Hedging and Insurance

Author(s): Jean Charles Rochet , Stéphane Villeneuve

Publication Date: November 2004

Keyword(s): liquidity risk , risk management , corporate hedging

JEL(s):

Programme Areas: Financial Economics

Link to this Page: www.cepr.org/pubs/dps/DP4755.asp

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.