Asset Illiquidity and Corporate Hedging

Distressed firms that are forced to liquidate assets in inefficient markets often have to accept prices that are substantially lower than the fair asset value. This asset illiquidity discount aggravates the financial situation of such firms and should be accounted for in risk management. This paper is the first to analyze financial hedging as a tool for avoiding exposure to the asset illiquidity discount. In our model the firm trades off the benefit of lowering the probability of asset fire sales against the cost of underinvestment resulting from the drain on cash when the firm buys insurance. We use the case of Saga Petroleum ASA, a Norwegian oil exploration company, to illustrate this tradeoff.