Market mulls forex options benchmark

Although other markets, such as the interest rate swaps market, have benchmark prices, the forex options business does not. And the need for an industry standard has become more acute following the introduction of accounting standards such as FAS 133 in the US and the upcoming IAS 39 standard for Europe, which require listed companies to report derivatives hedging accurately in their accounts.

"Firms are under pressure from their auditors to provide realistic mark-to-market prices," one senior New York forex options trader told RiskNews sister publication FX Week. "Because that is so difficult, firms are shying away from options and hedging is going down."

David Gershon, chief executive of options pricing vendor SuperDerivatives, agreed: "The accuracy of some pricing is not clear enough to allow clients to mark-to-market," Gershon said. "The fact that there is no standard price has had a big impact on liquidity. A benchmark would dramatically increase liquidity."

The British Bankers Association maintains a Reuters page which offers forex options volatilities amalgamated from 12 providers, published at 4pm London time on each trading day. But volatilities are just one component of pricing options - dealers also need to take into account the interest rate differential, forward points and the spot price, and then feed the information through a pricing model to calculate the price.

Many traders and clients currently use theoretical value to calculate their exposures, but some market participants believe this can result in costly inaccuracies - up to 15 pips, according to one dealer - because the market price is not being used. However, although these deviations do happen, the issue has less influence in the vanilla options market.

"Vanilla options have the largest volume, but the deviation from theoretical value is not that high," said Howard Savery, senior vice-president of business development at risk management vendor Derivatech in New York.

The majority of market participants polled by FX Week said that although a standard for marking options positions to market would be a useful development, the practicalities are much more complex.

"Options benchmarking is a great idea," said Sara Sullivan, senior manager, forex option sales at ANZ Investment Bank in London. "But in practice it would be very difficult. In the over-the-counter [OTC] market you can have an almost infinite number of variables in terms of strikes and expiry dates."

The OTC market is highly tailored, allowing clients to customise the options they trade to a high degree. For this reason, publishing a benchmark price for every possible option would prove almost impossible. Some banks believe options benchmarking is a moot point, as they are able to provide live market prices to allow clients to mark-to-market accurately.

UBS Warburg's electronic forex platform FX Option Trader, for example, offers price transparency in options giving users access to live, tradable market prices, a spokesperson told FX Week. "We provide live market prices that are totally auditable," the spokesperson said.

In other cases, dealers said, a client would more than likely request prices from several banks to mark-to-market positions, giving a representation of the market price.

To adopt a benchmark pricing standard, such as the type that exists in exchange-traded markets, an environment must be created whereby the amount of participants and the contracts they are trading are known. For example, the International Money Market at the Chicago Mercantile Exchange, where currency futures and options are traded, does have a benchmark. But even in that situation, traders using that exchange still complain about the benchmark price, market participants said.

Tentative steps are being made towards some kind of efficient benchmarking system. According to SuperDerivatives' Gershon, his firm is in negotiations with large accounting firms with a view to finding a solution to the mark-to-market problem, and other forex option participants are also believed to be readying benchmarking possibilities.

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