Journal of Operational Risk

Risk.net

Assimilating operational risks in common trading systems

Dror Parnes

We present a stochastic model that incorporates operational hazards within ordinary trading systems. We develop a simple compartmental theory that utilizes a predetermined lower threshold in the total assets' value to differentiate between operative and inoperative cycles in portfolio management. We then distinguish between two general failure modes, which may evolve due to either exogenous (market) or endogenous (operational) factors. We derive the pertinent time-related likelihoods of being in each state of nature, the accumulated probabilities of remaining operative or to breaching the predetermined lower boundary, and the expected time to portfolio termination, and hence the mean time to failure. We further simulate these derivations to demonstrate the model's universal functionality.

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