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An analysis of spending behaviour under liquidity constraints with an application to financial hedging

For counter-parties to an options contract, the method employed to hedge their exposures depends on the agents’ risk preferences and the underlying asset. The thesis begins with a rudimentary model exploring the effects of sequential decisions to an investment problem. The insights gained from this analysis are discussed, as are the refinements necessary for more detailed investigation of the problem under consideration. Incorporating these into the rudimentary model leads to the main model for the thesis, one which describes agents’ behaviour in a dynamically constrained optimisation framework, and holds similarities to models of markets for storable commodities. When combined with fundamental results about the quadratic variation of stochastic price processes, the model provides a link to option pricing. The analysis thus facilitates the development of a financial instrument that can assist agents in reducing the risk associated with volatility of corporate cash flows. The instrument can be priced using fundamental (financial statement) analysis and market prices, both of which also provide information related to corporate creditworthiness, thus allowing corroboration of the results from the option pricing model. Under a variety of assumptions related to this model, the behaviour of a set of inter-connected agents is simulated. The results are suggestive of structures in market prices whose characteristics of which can be described in terms of price volatility. This allows the calibration of option prices by means of wavelet-based price processes, which are especially suitable for modelling quadratic variation. Our model generates related time series for unit prices as well as quantity flows. Selected aspects of this are elaborated upon to illustrate areas for future application of the concepts developed in the thesis.