Liquidity Risk and Corporate Hedging with Futures ∗

This paper examines the hedging behavior of a value-maximizing firm that lasts for two periods. The firm faces uncertain income and is subject to tax asym-metries with no loss-offset provisions. The firm has access to unbiased futures contracts in each period for hedging purposes. We impose a liquidity constraint on the firm. Specifically, whenever the net interim loss due to its first-period futures position exceeds a predetermined threshold level, the firm is forced to terminate its risk management program and thus is prohibited from trading the futures contracts in the second period. We show that the liquidity constrained firm optimally adopts a full-hedge via its second-period futures position to mini-mize the extent of the income risk, and an under-hedge via its first-period futures position to limit the degree of the liquidity risk. JEL classification: D21; D8