Hedging under liquidity constraints

Dömötör, Barbara (2015) Hedging under liquidity constraints. Economy and Finance, 2 (1). pp. 46-59.

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Although risk management can be justified by financial distress, the theoretical models usually contain hedging instruments free of funding risk. In practice, management of the counterparty risk in derivative transactions is of enhanced importance, consequently not only is trading on exchanges subject to the presence of a margin account, but also in bilateral (OTC) agreements parties will require margins or collateral from their partners in order to hedge the mark-tomarket loss of the transaction. The aim of this paper is to present and compare two models where the financing need of the hedging instrument also appears, influencing the hedging strategy and the optimal hedging ratio. Both models contain the same source of risk and optimisation criterion, but the liquidity risk is modelled in different ways. In the first model, there is no additional financing resource that can be used to finance the margin account in case of a margin call, which entails the risk of liquidation of the hedging position. In the second model, the financing is available but a given credit spread is to be paid for this, so hedging can become costly.

Item Type:Article
Uncontrolled Keywords:risk management, hedging, financing liquidity
JEL classification:G17 - Financial Forecasting and Simulation
G32 - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
Divisions:Faculty of Business Administration > Institute of Finance and Accounting > Department of Finance
ID Code:2068
Deposited By: Ádám Hoffmann
Deposited On:23 Sep 2015 14:51
Last Modified:24 Sep 2015 08:55

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