Title: Liquidity, Futures Price Dynamics, and Risk Management
Reference Number: 1184
Publication Date: June 2008
JEL Classifcation: D21, D81, G13

Kit Pong Wong
The University of Hong Kong

This paper examines the optimal design of a futures hedge program by a competitive firm under output price uncertainty. Due to a capital constraint and the marking-to-market procedure of futures contracts, the firm faces endogenous liquidity risk. If the futures prices are sufficiently positively correlated, we show that the capital constraint is non-binding in that the optimal amount of capital earmarked to the futures hedge program is less than the firm's capital endowment. Otherwise, we show that the capital constraint becomes binding in that the firm optimally puts aside all of its capital stock for the futures hedge program. In the case of non-binding capital constraint, we show that the firm's optimal futures position is likely to be an over-hedge for reasonable preferences. In the case of binding capital constraint, the firm's optimal futures position is an under-hedge or an over-hedge, depending on whether the autocorrelation coefficient of the futures price dynamics is below or above a critical positive value, respectively.

Key words: Endogenous liquidation, Futures price dynamics, Marking to market, Prudence

Last modified: 06/11/2008