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.

We develop a dynamic model of a firm facing agency costs of free cash flow and external financing costs, and derive an explicit solution for the firm's optimal balance sheet dynamics. Financial frictions affect issuance and dividend policies, the value of cash holdings, and the dynamics of stock prices. The model predicts that the marginal value of cash varies negatively with the stock price, and positively with the volatility of the stock price. This yields novel insights on the asymmetric volatility phenomenon, on risk management policies, and on how business cycles and agency costs affect the volatility of stock returns.