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:
- Backoffices continuously collect data and recalibrate the pricing models, for example forward rates or option prices (volatilities) are used to calibrate SABR-Parameters.
- 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.
- 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?