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Risk management with options and futures under liquidity risk

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<mark>Journal publication date</mark>04/2009
<mark>Journal</mark>Journal of Futures Markets
Issue number4
Volume29
Number of pages22
Pages (from-to)297-318
<mark>State</mark>Published
<mark>Original language</mark>English

Abstract

Futures hedging creates liquidity risk through marking to market. Liquidity risk matters if interim losses on a futures position have to be financed at a markup over the risk-free rate. This study analyzes the optimal risk management and production decisions of a firm facing joint price and liquidity risk. It provides a rationale for the use of options on futures in imperfect capital markets. If liquidity risk materializes, the firm sells options on futures in order to partly cover this liquidity need. It is shown that liquidity risk reduces the optimal hedge ratio and that options are not normally used before a liquidity need actually arises.

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