Financial Hedging of Operational Risk Constraints: A General Framework

Abstract

We consider the operation of a non-financial corporation and present a novel risk-management framework that supports the joint optimization of the firm’s operational and financial decisions. Specifically, we study the problem of maximizing the firm’s operating profits when these profits depend on movements in the financial markets, and where the decision maker—the firm’s manager—is risk averse. Critically, our framework (i) imposes risk aversion through a generic class of risk constraints, and (ii) considers explicitly the differences that can exist between the shareholders’ and manager’s beliefs about future market risks. Together, these aspects allow us to remove speculation so that financial instruments can only be used for hedging purposes. We analyze our problem in an incomplete financial market setting and consider different informational assumptions. Within this framework, we characterize the optimal financial hedging strategy so that the problem reduces to a constrained maximization over operational policies. Our results show how financial hedging can be effectively used to expand the set of admissible operating policies, and identify conditions under which the risk constraint can be completely ignored when solving for an optimal operating policy. We illustrate our methodology in the context of an exporter firm which faces exchange rate risk in trading.