Title: Liquidity Constraints and the Hedging Role of Futures Spreads
Reference Number: 1089
Publication Date: January 2004
JEL Classifcation: D21, D81

Kit Pong Wong
The University of Hong Kong

This paper examines the behavior of the competitive firm under price uncertainty in general and the hedging role of futures spreads in particular. The firm has access to a commodity futures market where unbiased nearby and distant futures contracts are transacted. A liquidity constraint is imposed on the firm such that the firm is forced to prematurely close its distant futures position whenever the net interim loss due to its nearby and distant futures positions exceeds a threshold level. This paper shows that the liquidity constrained firm optimally opts for a long nearby futures position and a short distant futures position should the firm be prudent, thereby rendering the optimality of using futures spreads for hedging purposes. This paper further shows that the firm?s production decision is adversely affected by the presence of the liquidity constraint.

Published in The Journal of Futures Markets 24:10 (2004), pp. 909-921.

Key words: Marking to market, Liquidity constraints, Futures, Production

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Last modified: 01/24/2007