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Hedging, optimal capital structure and incentives for risk-shifting with preferences for liquidity

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  • Pengfei Luo
  • Ting Lu
  • DanDan Song
  • Jinglu Jiang

Abstract

We develop a dynamic incomplete-markets model of entrepreneurial firms and demonstrate the implications of preferences for liquidity to entrepreneur's interdependent consumption, portfolio allocation, hedging and financing decisions. The numerical results provide several important implications. Preferences for liquidity reduce hedging demand using risky assets. Besides, the existence of preferences for liquidity decreases the implied equity value and encourages the entrepreneur to issue more debt. Especially, the preferences for liquidity can overturn the risk-shifting incentives of a risk-averse entrepreneur.

Suggested Citation

  • Pengfei Luo & Ting Lu & DanDan Song & Jinglu Jiang, 2024. "Hedging, optimal capital structure and incentives for risk-shifting with preferences for liquidity," The European Journal of Finance, Taylor & Francis Journals, vol. 30(14), pages 1563-1576, September.
    • Handle: RePEc:taf:eurjfi:v:30:y:2024:i:14:p:1563-1576
    DOI: 10.1080/1351847X.2024.2310797
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