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Since it's obviously not at their fair value that derivatives are priced, how do investment banks compute the fees that they add on top of the risk neutral price ?

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As with everything else it is determined by competition: little or no competition => very high fees (or more correctly large bid-ask spreads). That is one reason why many IB try to develop new derivatives: they can be very profitable when no one else trades them yet. Then the cost comes down somewhat when competitors come in. Lack of transparency in pricing also helps the IBs (have you ever seen prices of OTC derivatives listed in the Wall Street Journal or any public place? Or an academic study of bid ask spread for i.r. swaps like you can find for listed stocks? I haven't).

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  • $\begingroup$ Does that mean that the fees are determined arbitrarily by IB in the case of let's say OTC options ? $\endgroup$ – BS. May 1 '16 at 19:33
  • $\begingroup$ Arbitrarily is perhaps too strong a word, but they are determined judgmentally after considering what other IB charge, the novelty and appeal of the derivative in question, the availability (or not) of close substitutes, the strategy of the IB (expand vs defend market share), and so on. Like any entrepreneur in a somewhat competitive, somewhat oligopolistic market... $\endgroup$ – Alex C May 1 '16 at 22:00

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