We analyze the demand for hedging and insurance by a firm facing cash-flow risks. We study how the firm’s liquidity management policy interacts with two types of risk: a Brownian risk that can be hedged through a financial derivative, and a Poisson risk that can be insured by an insurance contract. We find that the patterns of insurance and hedging decisions are pole apart: cash-poor firms should hedge but not insure, whereas the opposite is true for cash-rich firms. We also find non-monotonic effects of profitability. This may explain the mixed findings of empirical studies on corporate demand for hedging and insurance.

The on-going reform of the Basel Accord relies on three “pillars”: a new capital adequacy requirement, supervisory review and market discipline. This article develops a simple continuous-time model of commercial banks' behavior where interaction between these three instruments can be analyzed. We study the conditions under which market discipline can reduce the minimum capital requirements needed to prevent moral hazard. We also discuss regulatory forbearance issues.