Questioning assumptions

A dealer contacted Risk last month with an interesting story. Responsible for unwinding a sizeable equity derivatives portfolio at his firm, he was surprised by the wide variation in prices offered by banks for what he considered to be relatively commoditised option products.

The portfolio, for the most part, consisted of cliquets, Napoleon options and some correlation structures – products that pretty much every equity derivatives desk worth its salt would be able to quote prices on. However, the bids on some structures – particularly longer-dated options – varied extensively between banks. Perplexed, the dealer went back to the banks. "I checked with the most aggressive dealers, because we wanted to make sure they were confident in their pricing. We also checked with the most conservative and told them their prices were completely off. And every single bank came back and said they were absolutely certain that their price was correct."

Naturally, the dealer plumped for the most aggressive price. "There is no 'right' price in this business, and as far as I was concerned, the lowest price was the right price for me."

And there's the problem. There's a million and one reasons why the price quoted on a certain product could differ between dealers. It could be down to slight variations in the models used by dealers. It could be that one bank has an axe, enabling it to be a little more aggressive on the prices it quotes; perhaps another is charging a higher premium for taking the risk on to its books. But if the anomaly is down to overly aggressive assumptions, the bank that gets it most wrong is the one likely to get saddled with the trade.

It's a debate currently under way in the constant maturity swap (CMS) spread options market. These products have sprung up from virtually nowhere this year, with around $30 billion traded so far. However, there is a wide disparity in the prices offered by banks. Dealers say a variety of assumptions are needed to price these products, including implied volatility and correlation between the underlying CMS rates. And even minor variations in each of these assumptions can lead to significant differences in the final price.

There is no universal consensus on how to price CMS spread options, and there are few market prices with which to calibrate models. However, banks need to constantly question the assumptions being used in their models. If incorrect correlation assumptions are being used, banks could face nasty mark-to-market losses if the dynamics of the yield curve shift significantly (see pages 20–22).

Nick Sawyer, Editor