An Option-Based Operational Risk Management Model for Pandemics

North American Actuarial Journal, Vol 13, Issue (1): 54-76

40 Pages Posted: 24 Apr 2014

See all articles by Hua Chen

Hua Chen

University of Hawaiʻi at Mānoa

Samuel H. Cox

University of Manitoba - Asper School of Business

Date Written: December 08, 2008

Abstract

In this paper, we employ the theory of real option pricing to address problems in the area of operational risk management. Particularly, we develop a two-stage model to help firms determine the optimal suspension-reactivation triggers in the events of pandemics. In the first stage, we propose a regime-dependent epidemic model to simulate the spread of the virus, depending on whether the firm is active or inactive. In the second stage, we view the reactivation decision as a call option and the suspension decision as a put option, and use dynamic programming methods to obtain the optimal switching thresholds. Our method can be regarded as a quantitative implementation of the CDC’s instruction for pandemic preparation. We find that when they take the uncertainty of disease transmission into consideration, firms are more conservative about the decisions of suspension and reactivation. We also find that when firms incur switching costs, the suspension threshold increases with costs, whereas the reactivation threshold decreases with costs. By adopting disease control policies, firms can increase their values in both regimes.

Keywords: Real Option Valuation, Epidemic Risk, Operational Risk Management, Regime-Switching Model, Dynamic Programming

Suggested Citation

Chen, Hua and Cox, Samuel H., An Option-Based Operational Risk Management Model for Pandemics (December 08, 2008). North American Actuarial Journal, Vol 13, Issue (1): 54-76 . Available at SSRN: https://ssrn.com/abstract=2428600

Hua Chen (Contact Author)

University of Hawaiʻi at Mānoa ( email )

2404 Maile Way, E-602e
Honolulu, HI 96822
United States
(808) 956-8063 (Phone)
(808) 956-9887 (Fax)

Samuel H. Cox

University of Manitoba - Asper School of Business ( email )

181 Freedman Crescent
Winnipeg, Manitoba R3T 5V4
Canada

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