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Tax asymmetry and futures hedging under liquidity constraints
Author(s) -
Wong Kit Pong
Publication year - 2005
Publication title -
managerial and decision economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.288
H-Index - 51
eISSN - 1099-1468
pISSN - 0143-6570
DOI - 10.1002/mde.1223
Subject(s) - interim , futures contract , market liquidity , economics , hedge , incentive , forward market , financial economics , cash , monetary economics , microeconomics , finance , ecology , archaeology , biology , history
This paper examines the optimal futures hedging decision of a firm facing uncertain income that is subject to asymmetric taxation with no loss‐offset provisions. All futures contracts are marked to market and require interim cash settlement of gains and losses. The firm is liquidity constrained in that it is forced to prematurely close its futures position on which the interim loss incurred exceeds a threshold level. The liquidity risk created by the interim funding requirement of a futures hedge is shown to proffer the firm perverse incentives, thereby making an under‐hedge optimal. This under‐hedging result holds irrespective of whether the firm is risk neutral or risk averse. Copyright © 2005 John Wiley & Sons, Ltd.