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I'm curious about the typical markup on quoted exotic options as well as what drives this premium.

You call up an options desk for a quote, and they'll give you a spread that reflects their market on the vol plus a bunch of other things. (This spread might be deflected based on inventory, but let's ignore this aspect for a second.) Generally, what goes into the spread apart from the uncertainty about the forward vol? Is anything other than adverse selection priced in on top of the vol spread?

For a more concrete example, if I asked a desk to quote me a $1 strike 5-years-to-expiry call on Amazon, would they price this like pure delta? If there's a premium, what's driving that? What if I told the desk that I was committed to buying the option; would they still put a premium on the call?

For a more complex example, if I asked a desk to quote me a $1 strike perpetual call option on Amazon that can't be exercised for the next 5 years, would they price this like pure delta? If there's a premium, what's driving that (illiquidity of the exotic? adverse selection?) What if I told the desk that I was committed to buying the perpetual; would they still put a premium on the call?

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  • $\begingroup$ I think that uncertainty about the forward vol of the underlying is the main premium driver, as that uncertainty is directly linked to the cost of delta and gamma hedging, as alluded to in this answer here. Aside from the forward vol uncertainty, it would be the liquidity of (all other) options on the same underlying (other options cost = vega hedging cost). Amazon options are liquid, so the bid-offer spread should be tighter than on smaller names. $\endgroup$ Aug 30 at 9:27

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