Title: Liquidity Risk and the Hedging Role of Options
Reference Number: 1149
Publication Date: November 2005
JEL Classifcation: D21; D81; G13

Kit Pong Wong
The University of Hong Kong

Jianguo Xu
The University of Hong Kong

This paper 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 optimally purchase the unbiased option contracts in the first period if its utility function is quadratic or prudent. This paper thus offers a rationale for the hedging role of options when liquidity risk prevails.

Key words: Futures; Options; Multi-period hedging; Liquidity constraints; Prudence

Last modified: 11/04/2005