Optimal hedging strategy for risk management on a network

• We assess impact of a firm's financial interconnections on its hedging decisions.
• Framework incorporates characteristics of firms and their interconnections.
• An investment fund's equity risk transfer decisions are evaluated.
• We find that hedge costs greatly influence the choice of counterparties for hedging.
• Hedge decisions in the a posteriori analysis depend on risk management objectives.

The paper develops a network-based framework to assess the impact of a firm's financial interconnections and interdependencies on it optimal hedging and risk transfer strategy. This is important consideration as risk concentrations and propagation embedded in risk transfers pose as a significant challenge for financial regulations and risk management. Using an a priori and an a posteriori analysis, we investigate the impact of the network structure on optimal hedge decisions and hedge efficacy. The a priori analysis shows that network features play an important role in determining corporate hedging decisions through their impact on hedge costs. In the a posteriori analysis for counterparty risk, benefit of modification from the a priori optimal hedge decision is realized when variance of firm value matters, but not when tail risk measures are utilized. Financial network assessment indicates that an a priori analysis is insufficient for robust hedging decisions, and choice of risk measures behind risk management objectives dictates the extent of impact of network characteristics.