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Liquidity Risk and Corporate Demand for Hedging and Insurance

  • Rochet, Jean-Charles
  • Villeneuve, Stéphane

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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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4755.

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Date of creation: Nov 2004
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Handle: RePEc:cpr:ceprdp:4755
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  1. Tufano, Peter, 1996. " Who Manages Risk? An Empirical Examination of Risk Management Practices in the Gold Mining Industry," Journal of Finance, American Finance Association, vol. 51(4), pages 1097-1137, September.
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