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In this paper, the behavior of the competitive firm under price uncertainty when the firm has access to an intertemporally unbiased futures market is examined. Futures contracts are marked-to-market and thus require interim cash settlement of gains and losses. The firm is subject to a liquidity constraint in that it is forced to prematurely close its futures position on which the interim loss incurred exceeds a threshold level. It is shown that the liquidity constrained firm optimally opts for an under-hedge should it be prudent. Furthermore, the prudent firm cuts down its optimal level of output in response to the presence of the liquidity constraint. As such, the liquidity risk created by the interim funding requirement of a futures hedge adversely affects the hedging and production decisions of the competitive firm under price uncertainty. © 2004 Wiley Periodicals, Inc. Jrl Fut Mark 24:697-706, 2004
(ProQuest Information and Learning: ... denotes formulae omitted.)
INTRODUCTION
In 1993, MG Refining and Marketing, Inc. (MGRM), the U.S. subsidiary of the German industrial firm, Metallgesellschaft A. G., offered its customers fixed prices on oil and refined oil products up to 10 years into the future. To hedge against its exposure to oil prices, MGRM took on large positions in energy derivatives, primarily oil futures. When oil prices plummeted in 1993, the margin calls on MGRM's futures positions were so substantial that MGRM was unable to meet due to lack of sufficient liquidity.1 This resulted in a $2.4 billion rescue package coupled with a premature liquidation of the futures positions en masse so as to keep Metallgesellschaft A. G. from going bankrupt (Culp & Miller, 1995).
The case of Metallgesellschaft A. G. vividly demonstrates the importance of taking liquidity risk into account when devising risk management strategies. Indeed, the Committee on Payments and Settlement Systems (1998) identifies liquidity risk as one of the risks that users of derivatives and other financial contracts must consider. The purpose of this paper is thus to study the impact of liquidity risk on the behavior of the competitive firm under price uncertainty (Sandmo, 1971). To this end, the firm is restricted to use futures contracts for hedging purposes. Liquidity risk arises from the marking-to-market process of the futures contracts and from the inability of...