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Liquidity Risk and Corporate Demand for Hedging and Insurance

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  • Rochet, Jean-Charles
  • Villeneuve, Stéphane

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.

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Bibliographic Info

Paper provided by Institut d'Économie Industrielle (IDEI), Toulouse in its series IDEI Working Papers with number 254.

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Date of creation: May 2004
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Publication status: Published in Journal of Financial Intermediation, vol.�3, 2011, p.�300-323.
Handle: RePEc:ide:wpaper:2380

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References

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  1. Bruno Jullien & Georges Dionne & Bernard Caillaud, 2000. "Corporate insurance with optimal financial contracting," Economic Theory, Springer, vol. 16(1), pages 77-105.
  2. DeMarzo,Peter & Duffie,Darrel, 1989. "Corporate financial hedging with proprietary information," Discussion Paper Serie A 222, University of Bonn, Germany.
  3. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
  4. Smith, Clifford W. & Stulz, René M., 1985. "The Determinants of Firms' Hedging Policies," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 20(04), pages 391-405, December.
  5. Froot, Kenneth A & Scharfstein, David S & Stein, Jeremy C, 1993. " Risk Management: Coordinating Corporate Investment and Financing Policies," Journal of Finance, American Finance Association, vol. 48(5), pages 1629-58, December.
  6. Alistair Milne & A Elizabeth Whalley, 1999. "Bank capital and risk taking," Bank of England working papers 90, Bank of England.
  7. Mian, Shehzad L., 1996. "Evidence on Corporate Hedging Policy," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 31(03), pages 419-439, September.
  8. Allayannis, George & Ofek, Eli, 2001. "Exchange rate exposure, hedging, and the use of foreign currency derivatives," Journal of International Money and Finance, Elsevier, vol. 20(2), pages 273-296, April.
  9. Hayne E. Leland, 1998. "Agency Costs, Risk Management, and Capital Structure," Journal of Finance, American Finance Association, vol. 53(4), pages 1213-1243, 08.
  10. M. Martin Boyer, 2003. "Is the Demand for Corporate Insurance a Habit? Evidence from Directors' and Officers' Insurance," CIRANO Working Papers 2003s-42, CIRANO.
  11. Mello, Antonio S & Parsons, John E, 2000. "Hedging and Liquidity," Review of Financial Studies, Society for Financial Studies, vol. 13(1), pages 127-53.
  12. Stulz, ReneM., 1990. "Managerial discretion and optimal financing policies," Journal of Financial Economics, Elsevier, vol. 26(1), pages 3-27, July.
  13. Holmstrom, Bengt & Tirole, Jean, 2000. "Liquidity and Risk Management," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 295-319, August.
  14. Milne, Alistair & Robertson, Donald, 1996. "Firm behaviour under the threat of liquidation," Journal of Economic Dynamics and Control, Elsevier, vol. 20(8), pages 1427-1449, August.
  15. Stulz, René M., 1984. "Optimal Hedging Policies," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 19(02), pages 127-140, June.
  16. DeMarzo, Peter M & Duffie, Darrell, 1995. "Corporate Incentives for Hedging and Hedge Accounting," Review of Financial Studies, Society for Financial Studies, vol. 8(3), pages 743-71.
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Citations

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Cited by:
  1. Jean-Paul Décamps & Stéphane Villeneuve, 2007. "Optimal dividend policy and growth option," Finance and Stochastics, Springer, vol. 11(1), pages 3-27, January.
  2. Jean-Charles Rochet & Stéphane Villeneuve, 2005. "Corporate portfolio management," Annals of Finance, Springer, vol. 1(3), pages 225-243, 08.
  3. Anderson, Ronald W & Carverhill, Andrew, 2005. "A Model of Corporate Liquidity," CEPR Discussion Papers 4994, C.E.P.R. Discussion Papers.
  4. Anderson, Ronald W & Carverhill, Andrew, 2007. "Liquidity and Capital Structure," CEPR Discussion Papers 6044, C.E.P.R. Discussion Papers.
  5. Léautier, Thomas-Olivier & Rochet, Jean-Charles, 2012. "On the strategic value of risk management," TSE Working Papers 12-332, Toulouse School of Economics (TSE).
  6. Léautier, Thomas-Olivier & Rochet, Jean-Charles, 2013. "On the strategic value of risk management," TSE Working Papers 13-433, Toulouse School of Economics (TSE).
  7. Ronald W. Anderson & Andrew Carverhill, 2006. "Liquidity and capital structure," LSE Research Online Documents on Economics 24632, London School of Economics and Political Science, LSE Library.
  8. Léautier, Thomas-Olivier & Rochet, Jean-Charles, 2013. "On the strategic value of risk management," IDEI Working Papers 797, Institut d'Économie Industrielle (IDEI), Toulouse.
  9. Nataliya Klimenko, 2013. "Tailoring Bank Capital Regulation for Tail Risk," AMSE Working Papers 1310, Aix-Marseille School of Economics, Marseille, France, revised Feb 2013.
  10. Nataliya Klimenko, 2013. "Tailoring Bank Capital Regulation for Tail Risk," Working Papers halshs-00796490, HAL.

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