Operational risk of option hedging

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. (C) 2013 Elsevier B.V. All rights reserved.