Liquidity hedging with futures and forward contracts
Studies in Economics and Finance
ISSN: 1086-7376
Article publication date: 19 June 2019
Issue publication date: 21 June 2019
Abstract
Purpose
This paper aims to develop hedging strategies using both futures and forward contracts and issuing risky debt when financially constrained firms are forced to operate in long horizon.
Design/methodology/approach
The authors present a model for developing hedging strategies using both futures and forward contracts and issuing risky debt. A theoretical model employing stochastic differential equations for forward hedging is illustrated with a numerical example over parameter values consistent with the literature.
Findings
A financially constrained firm with limited cash balance must hedge its liquidity with both future and forward contracts and issue risky debt to support its long-term operations. The firm can issue a minimal amount of risky debt by adding forward contracts into hedging and can increase its value higher than that when hedging with only futures contracts. We show numerically that hedging with both futures and forward contracts allows the firm to issue minimal risky debt in increasing its firm value.
Practical implications
When Metallgesellschaft nearly collapsed in 1993, it offered long-term forward contracts to its customers and attempted to hedge its risk by rolling over series of short-term futures contract. It created the situation of inherent mismatch in maturity structure. A financially constrained firm operating in a long horizon appears to commit its liquidity as long-term forward contracts, which cannot be fully hedged with series of futures contacts. The firm should hedge its liquidity with both futures and forward contracts and avoid liquidation with deadweight costs in its long-term operation.
Originality/value
This is the first study examining hedging strategies with both futures and forward contracts.
Keywords
Citation
Shin, Y.J. and Pyo, U. (2019), "Liquidity hedging with futures and forward contracts", Studies in Economics and Finance, Vol. 36 No. 2, pp. 265-290. https://doi.org/10.1108/SEF-04-2018-0109
Publisher
:Emerald Publishing Limited
Copyright © 2019, Emerald Publishing Limited