Working Paper: CEPR ID: DP4755
Authors: Jean Charles Rochet; Stéphane Villeneuve
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: corporate hedging; liquidity risk; risk management
JEL Codes: No JEL codes provided
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| liquidity (E41) | hedging behavior (G41) |
| liquidity (E41) | insurance decisions (G52) |
| profitability (L21) | financial frictions (G19) |
| leverage (G24) | financial frictions (G19) |
| profitability and leverage (G32) | mixed empirical findings (C90) |