Optimal hedge ratio in a biased forward market under liquidity constraints

- Corporate hedging decision is modeled in a multi-period framework.
- Lower and upper bound of optimal hedge ratio are derived.
- Optimal hedge ratio is determined as a function of funding liquidity costs and the expected value of the forward hedge.
- Forward market bias has a significant effect on corporate hedging.

The paper1 investigates corporate hedging behavior in a theoretical model focusing on two important influencing factors: liquidity constraints affecting the funding opportunity of the firm and the extent of available hedging position, and speculative motive of risk management based on a bias of forward market. The optimal hedge ratio is analyzed in the function of three determining factors of the corporate utility function: the risk aversion ratio of the firm, the expected value of the hedge position, and the financing costs due to the hedging itself. The large empirical evidence of corporate over- and underhedge can be better understood in the presented framework.