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Optimal dynamic hedging using futures under a borrowing constraint

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  • Akash Deep

    (Harvard University - John F. Kennedy School of Government)

Abstract

Both financial and non-financial firms routinely implement hedging policies to mitigate their exposure to changes in asset prices. However, while these policies may perform satisfactorily in the limited sense of hedging the exposure under consideration, they might increase the overall likelihood of financial distress due to the liquidity risks that they create. This paper examines the case of hedging price risk using derivative contracts that are marked to market (such as futures contracts) and hence subject to margin calls. It is shown that liquidity risk, stemming from the need to meet margin calls on the futures position, can be a significant source of risk and can even lead to financial distress even though the firm remains "hedged". Such risks should therefore be taken into account in the formulation of an optimal hedging policy. This paper derives the dynamic hedging strategy of a firm that uses futures contracts to hedge a spot market exposure. The risk emanating from the margin requirement on futures contracts is incorporated into the hedging decision by restricting the borrowing capacity of the firm. It is shown that this leads to a substantial reduction in the firm's optimal hedge, especially if the hedging horizon is long. The results provide theoretical support for the low level of hedging observed empirically.

Suggested Citation

  • Akash Deep, 2002. "Optimal dynamic hedging using futures under a borrowing constraint," BIS Working Papers 109, Bank for International Settlements.
    • Handle: RePEc:bis:biswps:109
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    Citations

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    Cited by:

    1. Gert Schnabel, 2002. "Output trends and Okun's law," BIS Working Papers 111, Bank for International Settlements.
    2. Shi, Ruoding & Isengildina Massa, Olga, 2018. "Double-Edged Sword: Liquidity Implications of Futures Hedging," 2018 Annual Meeting, August 5-7, Washington, D.C. 274106, Agricultural and Applied Economics Association.
    3. Shi, Ruoding & Isengildina Massa, Olga, 2022. "Costs of Futures Hedging in Corn and Soybean Markets," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 47(2), May.
    4. Galvani, Valentina & Plourde, André, 2013. "Spanning with futures contracts," The Quarterly Review of Economics and Finance, Elsevier, vol. 53(1), pages 61-72.
    5. Dömötör, Barbara, 2017. "Optimal hedge ratio in a biased forward market under liquidity constraints," Finance Research Letters, Elsevier, vol. 21(C), pages 259-263.
    6. Serge Jeanneau & Marian Micu, 2002. "Determinants of international bank lending to emerging market countries," BIS Working Papers 112, Bank for International Settlements.
    7. Ankirchner, Stefan & Schneider, Judith C. & Schweizer, Nikolaus, 2014. "Cross-hedging minimum return guarantees: Basis and liquidity risks," Journal of Economic Dynamics and Control, Elsevier, vol. 41(C), pages 93-109.

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