Liquidity Risk and Hedging Decisions

Abstract

This paper studies the impact of liquidity risk on a firm's production and hedging decisions. Liquidity needs result from the revaluation of forward contracts prior to maturity and collateral calls in the case of losses. The provision of collateral causes financing costs, which depend on a firm-specific borrowing rate. Within a model of a risk-averse firm under price uncertainty, I derive bounds on optimal output quantities and hedge ratios for general utility functions and the special case of CRRA. It is shown that even firms with a high credit standing might reduce their forward positions substantially in response to liquidity risk. A model extension allows the firm to hedge its liquidity needs with call options. The analysis leads to different recommendations than previous studies, which focus on futures hedging under a borrowing constraint.

Keywords: Hedging, Forwards, Collateral, Liquidity, Risk Management

JEL Classification: G30, D81