A new framework for financial risk management

A new framework for financial risk management

With ESSEC Knowledge Editor-in-chief

If you’ve turned on the news in the last year and a half, you’ve heard about how COVID-19 has decimated the economy: many companies have taken a financial hit during the pandemic, and as we begin the economic recovery, they are looking at how to offset their losses. This highlights the need for financial risk management models that empower companies to make smart decisions and manage risk. To that end, myself (Andrea Roncoroni, professor of finance at ESSEC), and Paolo Guiotto (Università degli Studi di Padova) recently developed a framework for the optimal design of combined custom contingent claims, i.e. tailor-made financial derivatives that allow the buyer to jointly mitigate risks stemming from insurable and non-insurable exposure to uncertainty. Our model has been developed in Combined Custom Hedging: Optimal Design, Noninsurable Exposure, and Operational Risk Management (forthcoming in Operations Research). It allows companies to evaluate the benefits of using combined custom claims compared to single-claim hedges and to rank the corresponding performances, thus offering a strategic approach for even the most risk-averse firms. 

A model for combined custom contingent claims 

Generally speaking, firms want to maximize their expected profits, reduce uncertainty in their cash flow, or optimize some suitable combination of the two. We developed a rigorous mathematical model to design and analyze combined custom contingent claims, unifying past research streams into one single framework. This provides a methodology for optimally designing custom claims, to cope with mixed insurable and non-insurable risks. Our approach offers an evidence-based decision process to manage risk, namely the monetary benefit gained by switching from single claim to combined custom hedge, including ranking alternative options to get the full picture. 

In this context, customization refers to “tailoring a payoff written on a given underlying risk term” and combination stands for “assembling payoffs written on different underlying risk terms” (Roncoroni and Guiotto, p.1). Traditionally, they are often treated separately in claims, motivating the researchers to build an innovative methodology for combining them and assessing the benefits of the combination.

Part of the framework includes evaluating the combination value, i.e. the monetary value that makes a single-claim custom hedge as good as the optimal combined custom hedge. We also recognized that firms have varying approaches to risk management, and identified lower bounds for the combination value depending on a refinement of the well-known concept of risk aversion, which allows one to disentangle strictly from weakly risk averse firms. 

The model allows decision-makers to evaluate the incremental benefit that a firm, even a risk-averse firm, gains using a custom combined hedge approach compared to other options, offering a way to quantify its usefulness and benefits over other options. This permits analysis of the value enhancement from their optimal custom combined hedge when applied to business management and operations, i.e. the point when it outperforms other options. Firms can thus evaluate the gain they can expect from using this method compared to alternative hedges available for trading. This also offers a tool for the optimal risk management of corporate exposure.

This framework would have been useful had it been implemented before the COVID-19 pandemic, i.e. before an event occurring that hurts the company’s profits, given its proven utility for risk-averse firms experiencing a market shock.

Further, this model offers increased operational flexibility. Firms want accurate, well-designed contingent claims, and this model satisfies that need. 

Contributions 

The framework we developed offers an evidence-based, rigorous approach to combined custom hedging, including how to optimize and analyze the model while managing risk in a way that suits the firm’s financial practices. Different firms have different approaches to risk management, and this framework offers a way to design custom claims while keeping that in mind. The model offers a solution for designing optimal custom claims and also evaluating the benefit that this approach offers over other alternatives, making it useful for firms seeking to optimize their financial situation, introduce flexibility into their operations, and manage risk.

Reference

Guiotto, P., & Roncoroni, A. (2020). Combined custom hedging: Optimal design, noninsurable exposure, and operational risk management. Forthcoming in Operations Research.

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