The effect of liquidity constraints on futures hedging

This article assumes that because of liquidity constraints, a hedge program will be terminated if the cumulative loss from a futures position exceeds a certain threshold. The constraint leads to a smaller futures position. If the hedger has a quadratic utility function, then the optimal futures position is constant regardless of the parameter values and increases as the spot position or the conventional hedge ratio increases. When the capital allocation is small, the hedger tends to ignore this restriction and chooses a larger position. Consequently, the optimal position may decrease as the capital allocation increases. For a moderate capital allocation, the optimal position increases with an increasing capital allocation. Similar properties are established for exponential utility functions.