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Mercadian
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Options when there's no VolSurf - Emerging/Frontier Markets

July 24th, 2020, 7:38 pm

Hi!

My first post after the changes on the page from way back, apologies if I'm using the wrong forum, breaking some well known traditions/etiquette or simply asking to much of a dumb/general question.

I'm looking for some insight about option pricing or volsurf construction...


Context:
Most emerging/frontier markets have no or very thinly traded volatility surfaces for their different markets, furthermore they usually have restrictions on Short-Selling and Capital Controls.


Question:
How would you approach Pricing/EoD MtM for simple european calls/puts in this market conditions? I'm interested in heuristics/thought process, practical experience, literature references.


What I've got so far:
  1. Replication/cost of hedging... (usually hindered by some of the restrictions on short selling).
  2. Find a correlated asset that has the desired attributes (liquid spot/Vol and short selling) use this as a proxy.
  3. Use the underlying's historical spot market data**:
  • Using realized volatility / econometric / statistical projections.
  • Deduce a historical distribution single or rolling.

** Including accounting for regularities observed in proxy assets... like spread between RealizedVol vs ImpliedVol


Any insights would be greatly appreciated.


Thx!
M
 
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Alan
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Re: Options when there's no VolSurf - Emerging/Frontier Markets

July 24th, 2020, 8:25 pm

A naive question: even if there are no trades, what's wrong with using the EOD mid-quote? 
 
Mercadian
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Re: Options when there's no VolSurf - Emerging/Frontier Markets

July 24th, 2020, 9:04 pm

Hi Alan,

Thank you for your reply, please let me offer my naive answer here:


A naive question: even if there are no trades, what's wrong with using the EOD mid-quote?
Indeed, I agree with you, if there's a "thinly traded" volsurface and there were no trades on a given day you could still go for the mid for EoD valuation.

I guess, and apologies for my confusion, my question got off focus by the way I presented the context, indeed, I'm more interested in a situation where there isn't a volsurface in the first place... or if there is, it's a "thinly quoted" volsurface rather than an "thinly traded" one (I know its like two faces of the same coin, but hear me out).

The reason I added the "thinly traded quoted volsurface" piece, is because in such situations you're really exposed to market manipulation or simply to stale MtMs/valuations which over/under estimate your risk and PnL and limit market making... this in turn feeds the lack of quotes which ends gets us to the top of the argument generating a sort of "vicious cycle"... maybe a way tackle this problem is by generating theoretical prices through some of the approaches I listed... which going back to the Market Maker... would allow it to anchor its prices on liquid instruments, hedge its positions and provide a release valve for risk on its book thus allowing the market marker more latitude to offer pricing/liquidity which in turn helps revert the "vicious cycle".

Of course there's a lot of caveats to it, but its the general idea behind the question.

Thx,
M
 
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Alan
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Re: Options when there's no VolSurf - Emerging/Frontier Markets

July 25th, 2020, 4:21 pm

So, it now sounds like your real question is: how to be a Market Maker in such markets. Is it?

One answer might be: if you have to ask …  :D

Or, perhaps someone (not me) with IB experience making two-sided OTC markets in, say, exotic options, might give some non-proprietary general clues beyond what you've already got.  My suspicion is that you first need to have market making experience in a developed options market ... 
 
Mercadian
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Re: Options when there's no VolSurf - Emerging/Frontier Markets

July 27th, 2020, 1:27 pm

Hi Alan,

Thank you for your reply, re:


So, it now sounds like your real question is: how to be a Market Maker in such markets. Is it?

This isn't really my question, but as is the case with market data there's always a way to connect it to any activity... I basically pointed to market making in my previous comment just to give some examples of the impacts of using the mid price of a thinly quoted volsurf at the core of price formation, I could have used a Buy Side, Risk, IPV or Quant generalist perspective as well, to me its all commutable as the question from my side is centered around manufacturing synthetic market data.  

Thx,
M
 
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Alan
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Re: Options when there's no VolSurf - Emerging/Frontier Markets

July 27th, 2020, 3:28 pm

Fair enough. How about a specific security, country, and exchange as an example? Take a 30-day at-the-money call and put. What do your various approaches so far yield as option values?

Also, here's a couple specific suggestions. 

First, let's say you have 4 methods. Practice using them on listed options where there's an EoD quote, but perhaps other constraints are present such as no short selling. You could run regressions or other optimizers for the best linear combos as predictors of existent quotes. Perhaps that same optimal combination is a good "value" when there's no quote. 

Second, construct a VIX-style index for each exchange you want to make (synthetic) quotes for. Use it to improve the fits. (The "old VIX" methodology may be useful here).  
 
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SeftonBoyd
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Re: Options when there's no VolSurf - Emerging/Frontier Markets

July 27th, 2020, 9:02 pm

I think you've checked most of the boxes, but FWIW here's my two cents based on my FX market-making experience (with a couple of assumptions...)

Assumptions: 
- Local regulators aren't going to go all Medieval on you and try to take you to court for being viewed as a traitorous speculator.
- Whats the local banking system / FX market like? If its a tight-knit community you'll be the last to know what's happening and will likely get carved up like Frank Slade's Thanksgiving Turkey

With that out of the way,

1) Can you measure the realised volatility of the Outright Forward/NDF? This would give me at least  an idea of roughly where the big figure should be to the ATM
2) Anything regional that exhibits any degree of correlation? I know that underlying can be correlated, until they aren't (which is when things are going tits up), but this can also help with assumptions for Fly and Riskie pillars.
3) What does the CB do in the spot market? Because I've encountered a CB that used to have no problem in telling me that their published spot rates were only for local corporates and not Johnny Foreigner. You also need to know what sort of currency policy they follow (any bands, baskets, etc.)
4) What sort of market data access do you have? Again, you have to measure what you can trade rather than what is advertised.
5) Who is going to be on the other side of my prices? In some places corporates will lump you with as much gamma as possible, so marking then necessarily becomes influenced by supply/demand practicalities (i.e. I may need to mark ATMs low but still keep the RR steep to accommodate the asymmetry of outright forwards velocity).
 
 
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Alan
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Re: Options when there's no VolSurf - Emerging/Frontier Markets

July 28th, 2020, 2:36 pm

Great post  -- I wish we had more with your type of experience!
 
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fomisha
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Re: Options when there's no VolSurf - Emerging/Frontier Markets

July 29th, 2020, 5:07 pm

The general principle is that you should price the risk factors you can hedge at the price of hedging plus the cost of doing business and the risks you cannot hedge at the unbiased estimate under P measure plus the cost of capital associated with holding the corresponding risk.
If you are a market maker, you should separately count adverse selection and market impact as well.

For example, if you cannot short the underlier, the underlier price would be the market price of the underlier if you are short delta. If you get into a long delta position you can require 20% annualized return on the synthetic equity position you cannot hedge. If you can hedge some of that risk with a proxy (e.g. index) you can require some return on the basis between the proxy hedge and the underlier.
 
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fomisha
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Re: Options when there's no VolSurf - Emerging/Frontier Markets

July 29th, 2020, 5:10 pm

For formal methods you can search for utility indifference pricing.
 
Mercadian
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Re: Options when there's no VolSurf - Emerging/Frontier Markets

August 6th, 2020, 6:21 pm

Hi Alan, SeftonBoyd and Fomisha,

I've been short on time this past weeks but I just wanted to thank you all for the great insights, you've given me lots to think and read about, I'll try to circle back on this thread after some more research and share more thoughts on this.

Thx,
M
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