Risk Management in the Network Economy

This paper investigates the role of risk management networks in formulating hedging strategies. We develop a framework that delineates how the pattern of risk management linkages determines a firm’s hedging costs and characterizes its optimal network structure. Consistent with empirical evidence, the model predicts an inverted U-shaped relationship between the firm’s optimal hedging ratio and the number of its risk takers. Moreover, we find that a linked network may be optimal ex ante even though linkages among risk takers may spread financial contagion, supporting the model’s prediction regarding network cohesion.