Explain possible ways of marking over-the-counter contracts

Question

Explain all possible ways of marking over-the-counter contracts.

Answer 1

Here are some possible ways of marking over-the-counter contracts.

• The trader utilizes his own volatility. Perhaps his finest forecast going forward. It is very easy to abuse; this is very easy to rack up an imaginary profit that 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 tradeable prices, unprejudiced and real. The main drawback is as you cannot be forever calling brokers for prices along with no intention of trading. They find very annoyed. But they won’t provide you tickets to Wimbledon anymore.

• Utilize a volatility model that is calibrated to vanillas. It has the advantage of providing prices which are consistent along with the information in the market, and are thus 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 way and the hedging of derivatives. Get the simple case of a vanilla equity option bought since it is considered cheap.