Combined Custom Hedging: Optimal Design, Noninsurable Exposure, and Operational Risk Management

Forthcoming in Operations Research

83 Pages Posted: 2 Feb 2021

See all articles by Paolo Guiotto

Paolo Guiotto

University of Padova

Andrea Roncoroni

ESSEC Business School

Date Written: November 30, 2020

Abstract

We develop a normative framework for the optimal design, value assessment, and risk management integration of combined custom contingent claims. A risk averse firm faces a mix of financially insurable and noninsurable risk. The firm seeks optimal positioning in a pair of custom claims, one written on the insurable term, and another written on any listed index correlated to the noninsurable term. We prove that a unique optimum always exists unless the index is redundant, and show that the optimal payoff schedules satisfy a design integral equation. We assess the firm’s incremental benefit in terms of both an indifference value and an efficiency rating: this benefit increases with the correlation of the index to the noninsurable term, and it decreases with the correlation of the index to the insurable term. Our hedge proves empirically relevant for a highly risk averse firm facing a market shock (COVID-19 pandemic). In the context of a newsvendor model featuring random price and demand, we show that: (i) integrating our optimal combined custom hedge with the corresponding optimal procurement policy allows the firm to obtain a significant improvement in both risk and return; (ii) this gain may be traded off for a substantial enhancement in operational flexibility.

Keywords: Integrated risk management, Noninsurable risk, Financial product design, COVID-19 pandemic

JEL Classification: C44, G22, G23, G32, D81

Suggested Citation

Guiotto, Paolo and Roncoroni, Andrea, Combined Custom Hedging: Optimal Design, Noninsurable Exposure, and Operational Risk Management (November 30, 2020). Forthcoming in Operations Research, Available at SSRN: https://ssrn.com/abstract=3775182 or http://dx.doi.org/10.2139/ssrn.3775182

Paolo Guiotto

University of Padova ( email )

via Trieste 63
Padova, Padova 35121
Italy
+393920484128 (Phone)

Andrea Roncoroni (Contact Author)

ESSEC Business School ( email )

Avenue Bernard Hirsch BP 50105
Cergy-Pontoise, 95021
France
+33 (0)1 34 43 32 39 (Phone)
+33 (0)1 34 43 30 01 (Fax)

HOME PAGE: http://www45.essec.edu/faculty/andrea-roncoroni

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