This paper presents an alterative: a firm-theoretic model of bank behavior with financial futures under deposit insurance. Assuming that the bank is a certificate of deposit (CD) rate-setter and faces random CDs, expressions for the optimal futures hedge are derived under the option-based valuation. When the bank is in a bad state of the world, a decrease in the short position of the futures decreases the loan rate and increases the CD rate; an increase in the deposit insurance premium increases the loan rate and decreases the CD rate. | Yugoslav Journal of Operations Research 14 (2004), Number 2, 209-218 LIQUIDITY MANAGEMENT AND FUTURES HEDGING UNDER DEPOSIT INSURANCE: AN OPTION-BASED ANALYSIS* Jyh-Horng LIN Graduate Institute of International Business, Tamkang University Tamsui Campus, Tamsui, Taipei, Taiwan, lin9015@ Chuen-Ping CHANG Graduate Institute of Management Sciences, Tamkang University, Taipei, and Department of Information Management, Diwan College of Management Tainan, Taiwan cpchang@ Received: December 2002 / Accepted: February 2004 Abstract: Theories on financial futures hedging are generally based on a portfolio-choice approach. This paper presents an alterative: a firm-theoretic model of bank behavior with financial futures under deposit insurance. Assuming that the bank is a certificate of deposit (CD) rate-setter and faces random CDs, expressions for the optimal futures hedge are derived under the option-based valuation. When the bank is in a bad state of the world, a decrease in the short position of the futures decreases the loan rate and increases the CD rate; an increase in the deposit insurance premium increases the loan rate and decreases the CD rate. We also show that the bank’s amount of futures increases with a lower expected futures interest rate. Keywords: Liquidity, futures, deposit insurance, Black-Scholes valuation. 1. INTRODUCTION It is widely recognized that liquidity management is on the front line of the banking business. A number of money-center banks have experienced liquidity problems * JEL Classification: G13, G21 210 . Lin, . Chang / Liquidity Management and Futures Hedging that inevitably involve estimating fund needs, which is related to net deposit flows and varying levels of loan commitments, or meeting liquidity needs, which is related to asset liquidity and liability liquidity. Bank asset-liability managers are especially concerned with stabilizing their margin, or the spread between their bank’s interest
