Liquidity Risk and Corporate Demand for Hedging and Insurance

40 Pages Posted: 8 Feb 2005

See all articles by Jean-Charles Rochet

Jean-Charles Rochet

University of Toulouse Capitole - Toulouse School of Economics

Stephane Villeneuve

University of Toulouse 1 - Toulouse School of Economics (TSE)

Date Written: November 2004

Abstract

We analyze 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

Suggested Citation

Rochet, Jean-Charles and Villeneuve, Stéphane, Liquidity Risk and Corporate Demand for Hedging and Insurance (November 2004). Available at SSRN: https://ssrn.com/abstract=663403

Jean-Charles Rochet (Contact Author)

University of Toulouse Capitole - Toulouse School of Economics ( email )

Toulouse
France

Stéphane Villeneuve

University of Toulouse 1 - Toulouse School of Economics (TSE) ( email )

Place Anatole-France
Toulouse Cedex, F-31042
France