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Operational risk of option hedging

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  • Mitra, Sovan

Abstract

Operational risk is increasingly being recognised as a significant area of risk and regulation, yet there exists relatively little research on it. In this paper we show that operational risk represents a fundamental risk to option hedging and investigate it by proposing a new theoretical model. We derive an exposure indicator for the operational risk of option hedging and the resulting operational risk distribution. We obtain analytical results for various risk measures including the Value at Risk equation; this includes deriving a new analytical result for the quantile function of the half-normal distributions (which will be of interest to Statisticians in general). We determine an analytical solution to the price of options under operational risk. We conduct numerical experiments on empirical option data to validate our model and estimate the operational Value at Risk for option hedging.

Suggested Citation

  • Mitra, Sovan, 2013. "Operational risk of option hedging," Economic Modelling, Elsevier, vol. 33(C), pages 194-203.
    • Handle: RePEc:eee:ecmode:v:33:y:2013:i:c:p:194-203
    DOI: 10.1016/j.econmod.2013.04.031
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    References listed on IDEAS

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    1. Sovan Mitra & Tong Ji, 2010. "Risk measures in quantitative finance," International Journal of Business Continuity and Risk Management, Inderscience Enterprises Ltd, vol. 1(2), pages 125-135.
    2. Friedrich Hubalek & Jan Kallsen & Leszek Krawczyk, 2006. "Variance-optimal hedging for processes with stationary independent increments," Papers math/0607112, arXiv.org.
    3. Loader, David, 2002. "Controls, Procedures and Risk," Elsevier Monographs, Elsevier, edition 1, number 9780750654869.
    4. Schwert, G William, 1989. " Why Does Stock Market Volatility Change over Time?," Journal of Finance, American Finance Association, vol. 44(5), pages 1115-1153, December.
    5. Kevin Dowd & David Blake, 2006. "After VaR: The Theory, Estimation, and Insurance Applications of Quantile‐Based Risk Measures," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 73(2), pages 193-229, June.
    6. Kabir, M. Humayun & Hassan, M. Kabir, 2005. "The near-collapse of LTCM, US financial stock returns, and the fed," Journal of Banking & Finance, Elsevier, vol. 29(2), pages 441-460, February.
    7. Sovan Mitra, 2010. "Regime switching stochastic volatility option pricing," International Journal of Financial Markets and Derivatives, Inderscience Enterprises Ltd, vol. 1(2), pages 213-242.
    8. Tan, Abby, 2006. "Long-memory volatility in derivative hedging," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 370(2), pages 689-696.
    9. Stonham, Paul, 1999. "Too close to the hedge: the case of long term capital management LP: Part two: near-collapse and rescue," European Management Journal, Elsevier, vol. 17(4), pages 382-390, August.
    10. Pinder, Sean, 2003. "An empirical examination of the impact of market microstructure changes on the determinants of option bid-ask spreads," International Review of Financial Analysis, Elsevier, vol. 12(5), pages 563-577.
    11. Sovan Mitra, 2011. "Energy-based assets: modelling, option pricing and delta hedging with transaction costs," International Journal of Sustainable Economy, Inderscience Enterprises Ltd, vol. 3(1), pages 20-43.
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    Cited by:

    1. Raimonda Martinkutė-Kaulienė, 2014. "Risk Factors in Derivatives Markets," Entrepreneurial Business and Economics Review, Centre for Strategic and International Entrepreneurship at the Cracow University of Economics., vol. 2(4), pages 71-83.
    2. Sovan Mitra & Andreas Karathanasopoulos, 2019. "Firm Value and the Impact of Operational Management," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 26(1), pages 61-85, March.

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