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As a follow up to a recent question on why market prices and model prices can sometimes differ substantially, this resulted in a new question.

How do traders come up with prices?


Example: Let's say someone wants to buy a swaption. I always assumed it worked like this:

  1. Backoffices continuously collect data and recalibrate the pricing models, for example forward rates or option prices (volatilities) are used to calibrate SABR-Parameters.
  2. A trader who wants to sell a swaption uses the bank's pricing library to get an estimate for the fair value of the swaption.
  3. The trader adds a few basis points to the NPV from step 2 as a fee.

This does not seem to be the standard approach, so what is actually happening?

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  • $\begingroup$ Actually that is not a bad description in many cases (highly standard products). But keep in mind that the models require inputs some of which may involve human judgement, they can't always be extracted from market data. $\endgroup$ – noob2 Aug 29 '16 at 12:45
  • $\begingroup$ @noob2 my impression is that the example can not be the whole story otherwise market prices would follow model prices much closer. One guess would be: some market participants use more sophisitcated proprietary models? $\endgroup$ – Beginner Aug 29 '16 at 13:14
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    $\begingroup$ @drobertson I am curios to hear your "Parable of the efficient market". $\endgroup$ – Beginner Aug 29 '16 at 13:16
  • $\begingroup$ @noob2 with human judgement do you mean parameters such as grid spacing, interpolation method, etc? $\endgroup$ – Beginner Aug 29 '16 at 13:17
  • $\begingroup$ '@beginner' more than that. for example for CDO models the correlation of defaults was very difficult to estimate, little more than a guess which proved to be way off. $\endgroup$ – noob2 Aug 29 '16 at 13:29
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You have two main reasons why market prices are not all perfectly aligned with models:

  • each bank uses its own model, its own libraries to calibrate, and its own corrected market prices. You can see this reason as the secret sauce of each bank / desk.
  • liquidity costs are different from one trade and bank to another: (1) do not forget you have different bid and ask prices for the same product (hence for illiquid products the market prices are transaction prices; they can be different for buys than for sells); (2) when collateralization is needed, the availability and price for collateral can be different from one bank to another; (3) last but not least banks take their inventory into account, if you already sold a lot of risk in one direction, you will now sell it at an higher price (to try to net your inventory back to zero).

To be frank there is a third reason, but I do not like it: some banks / desks may have appetite for risk in given directions. They are ready to take risk. Hence the difference between the "fair price" (in your views: i.e. price that models are telling) and the proposed price can be different. I do not like this third case because banks should be intermediaries (i.e. act as market makers).

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    $\begingroup$ "Motive" is also a factor. My old trader also had the tendency to mark things in such a way that his own PnL volatility is dampened. His quotes basically mean-reverts toward "market" value... $\endgroup$ – Helin Aug 29 '16 at 18:49

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