Financial Hedging of Operational Risk Constraints: A General Framework

In this paper we consider the operations 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 in part 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 tail risk constraints and (ii) considers explicitly the differences than can, and often do, exist between the market's and manager's probabilistic assessments of future market risks. We analyze this 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 (from a risk management standpoint), and identify conditions under which the risk constraints can be completely ignored when solving for an optimal operating policy. In such cases, operational and financial decisions essentially decouple. We illustrate our methodology in the context of an exporter firm, which faces exchange rate risk in trading.