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Liquidity risk and the hedging role of options

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  • Kit Pong Wong
  • Jianguo Xu

Abstract

This study examines the impact of liquidity risk on the behavior of the competitive firm under price uncertainty in a dynamic two‐period setting. The firm has access to unbiased one‐period futures and option contracts in each period for hedging purposes. A liquidity constraint is imposed on the firm such that the firm is forced to terminate its risk management program in the second period whenever the net loss due to its first‐period hedge position exceeds a predetermined threshold level. The imposition of the liquidity constraint on the firm is shown to create perverse incentives to output. Furthermore, the liquidity constrained firm is shown to purchase optimally the unbiased option contracts in the first period if its utility function is quadratic or prudent. This study thus offers a rationale for the hedging role of options when liquidity risk prevails. © 2006 Wiley Periodicals, Inc. Jrl Fut Mark 26:789–808, 2006

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  • Kit Pong Wong & Jianguo Xu, 2006. "Liquidity risk and the hedging role of options," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 26(8), pages 789-808, August.
    • Handle: RePEc:wly:jfutmk:v:26:y:2006:i:8:p:789-808
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    Cited by:

    1. Matthias Pelster, 2015. "Marketable and non-hedgeable risk in a duopoly framework with hedging," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 39(4), pages 697-716, October.
    2. Elisson Andrade & Fabio Mattos & Roberto Arruda de Souza Lima, 2018. "New Insights on Hedge Ratios in the Presence of Stochastic Transaction Costs," Risks, MDPI, vol. 6(4), pages 1-15, October.
    3. Matthias Pelster, 2014. "Implications of financial transaction costs on the real economy: A note," Contemporary Economics, University of Economics and Human Sciences in Warsaw., vol. 8(1), March.

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