Optimal Hedging Strategy for Risk Management on a Network

Abstract

In this paper, we derive and assess a framework in which a firm's financial environment is an integral part of its hedging decisions. In the framework, the characteristics of firms in the network and their interconnections affect the firm's risk management strategy through impact on contract cost and efficacy of protection. We apply the model to an investment fund's decision making problem for transferring equity risk to a set of banks and obtain its optimal hedging decision based on a risk-return tradeoff analysis. We find hedge costs greatly influence the fund's choice of counterparties for contract: the cost advantage of a counterparty would award it a dominant role in the magnitude of protection sought from the counterparty. In the a posteriori analysis, we evaluate the hedge efficacy in terms of the counterparties' ability to honor the hedge contract. We investigate counter-party risk by introducing network-caused default probability and recovery rate to our model. We find that the objective and measures used for corporate risk management decide the optimality of hedge contract in the a posteriori analysis. Firms focusing on minimizing variance of firm value might consider a small deviation from the a priori optimal strategy; while those focussed on tail risk tend to stay with the a priori optimal strategy.