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I am starting to work on building vol surfaces using implied vols on the short run mixed up with consensus vols ran through a whole bunch of interpolation/calibration/smoothing process.

Although I start to understand the math behing it I am still trying to make sense of the impact on PNL when pricing. From what I read I feel like it is more important to be close to consensus than to be right about future vols. I also wonder why we can't imply those vols from the price of bank exots the same way we imply it from calls and puts on the short run. It seems to be the bread and butter for banks to better fit longer term vols based on consensus that are often quite far from realized vols or from forecasted vols using ARCH-type models and I want to make sure I understand why.

Thanks a lot for taking the time to read!

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  • $\begingroup$ What exactly do you mean by being right about future vols? Exotics don't have a clear one for one mapping between price & vol like in the BS world. At the end of the day, how much you pay will be determined by the market maker(s). Unless you are a market maker, your main goal is to match quotes as close as possible (to get accurate PnL, Mark to Market etc). Many exotic models like SLV are implemented with local vol being based on a vanilla surface, and mixing fractions etc being calibrated to match exotic (barrier options etc.), but having reliable quotes for these is often not realistic. $\endgroup$
    – AKdemy
    Sep 29 at 9:11
  • $\begingroup$ Thanks a lot that makes more sense ! $\endgroup$ Sep 29 at 10:33
  • $\begingroup$ "being right about future vols" with this I refer to traders telling me being closer to other banks is more important than being closer to what the vol will be. But I think you answered this: you need to have a clear idea of what vol market makers price because you won't have marked to market prices for exots so all your price/PNL calculation are theorictical and based on those vols. Right? $\endgroup$ Sep 29 at 10:45
  • $\begingroup$ What the (realized) vol will be? Implied vols exhibit a smile (smirk, skew, whatever you want to call it) which means that vols depend on strike (moneyness, delta). (Accurately) forecasting realized vol is only of limited use for option pricing (definitely for building vol surfaces). Even if you had reliable quotes for exotics, you would still try to match (calibrate to) these quotes with your model of choice. $\endgroup$
    – AKdemy
    Sep 29 at 10:59

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