The effect of liquidity constraints on futures hedging

✍ Scribed by Donald Lien

• Publisher: John Wiley and Sons
• Year: 2003
• Tongue: English
• Weight: 96 KB
• Volume: 23
• Category: Article
• ISSN: 0270-7314
• DOI: 10.1002/fut.10075

✦ Synopsis

Abstract

This article assumes that because of liquidity constraints, a hedge program will be terminated if the
cumulative loss from a futures position exceeds a certain threshold. The constraint leads to a smaller futures
position. If the hedger has a quadratic utility function, then the optimal futures position is constant regardless
of the parameter values and increases as the spot position or the conventional hedge ratio increases. When the
capital allocation is small, the hedger tends to ignore this restriction and chooses a larger position.
Consequently, the optimal position may decrease as the capital allocation increases. For a moderate capital
allocation, the optimal position increases with an increasing capital allocation. Similar properties are
established for exponential utility functions. © 2003 Wiley Periodicals, Inc. Jrl Fut Mark 23:603–613,
2003