Define possible ways of marking exotic/over-counter contract

Question

What are possible ways of marking exotic or over-the-counter contracts?

Answer 1

Several possible ways of marking exotic or over-the-counter (OTC) contracts are as follows:

• The trader utilizes his own volatility. Perhaps his excellent forecast going forward. It is very easy to abuse; this is very easy to rack up an imaginary profit this way.
Whatever volatility is used this cannot be too far from the market’s implied volatilities upon liquid options with similar underlying.

• Use prices acquired from brokers. It has the advantage of being real, trade-able prices, and unprejudiced. The major drawback is that you cannot be forever calling brokers for prices along with no intention of trading. They find very annoyed. And they won’t provide you tickets to Wimbledon anymore.

• Utilize a volatility model which is calibrated to vanillas. It has the advantage of giving prices which are consistent along with the information in the market, and are so arbitrage free. Though, there is always the question of that volatility model to utilize, deterministic and stochastic, etc., therefore ‘arbitrage freeness’ is in the eye of the modeller. This can also be time consuming to have to crunch prices often. One subtlety concerns the marking process and the hedging of derivatives.