Liquidity Risk Hedging

Long-term bonds are exposed to higher interest-rate risk, or duration, than short-term bonds. Conventional interest-rate risk management prescribes that a firm structure the maturity of its liabilities in order to hedge the duration of its long-term assets (?). By doing so, the firm’s assets and liabilities move in lockstep, and its net equity is shielded from (at least small) movements in interest rates. In situations in which the firm is constrained from achieving perfect interest-rate risk hedging, the conventional prescription is to match the duration of its liabilities to that of its assets as closely as possible. In reality, a firm’s assets are also exposed to sources of risk other than interest rates. These sources of risk can drive a wedge between the firm’s financing cost and the riskless interest rate, and in extreme circumstances, the firm may be unable to borrow entirely. In particular, funding liquidity risk arises whenever the firm is unable to rollover its liabilities. Liquidity risk reflects the danger that a firm may be forced to liquidate its assets in a fire sale, even when it is socially optimal to continue funding the project until maturity. In this paper, we develop a concept called liquidity risk hedging in analogy to interest-rate risk hedging. We find that the prescriptions of liquidity risk management can be substantially different from conventional interest-rate risk management. In particular, liquidity risk hedging can prescribe financing that is more “short term” than conventional interest-rate risk management. We provide first a three-period example where it is better to issue a one∗Brunnermeier: Department of Economics, Princeton University, 26 Prospect Avenue, Princeton, NJ 08540 and NBER (e-mail: [email protected]); Yogo: Finance Department, The Wharton School, University of Pennsylvania, 3620 Locust Walk, Philadelphia, PA 19104 and NBER (e-mail: [email protected]).