Title: Tax Asymmetry and Futures Hedging under Liquidity Constraints
Reference Number: 1110
Publication Date: August 2004
JEL Classifcation: D21, D81

Kit Pong Wong
University of Hong Kong

This paper examines the optimal futures hedging decision of a firm facing uncertain income that is subject to asymmetric taxation with no loss-offset provisions. All futures contracts are marked to market and require interim cash settlement of gains and losses. The firm is liquidity constrained in that it is forced to prematurely close its futures position on which the interim loss incurred exceeds a threshold level. The liquidity risk created by the interim funding requirement of a futures hedge is shown to proffer the firm perverse incentives, thereby making an under-hedge optimal. This under-hedging result holds irrespective of whether the firm is risk neutral or risk averse.

Published in Managerial and Decision Economics 26 (2005), pp. 271-281.

Key words: Marking to market; Futures; Tax asymmetry; Liquidity constraints

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Last modified: 01/24/2007