QuoteOriginally posted by: CaesariaQuoteOriginally posted by: PaulQuoteOriginally posted by: Caesaria Lets say that I am Goldman Sachs, and you want to buy a variance swap on a November future for Crude. You have a business need for this swap, ...What should I do, should I sell you that Nov Crude Variance Swap?Fantastic questions! The answer could consist of any or all of: Reduce volume, perhaps to zero; Statically hedge; Charge highest price you can get away with; Diversify; Make market in something as similar as possible; Play the odds, estimate standard deviations; Hope; Pray; Make sure your boss knows your concerns and ok's whatever you do. And probably many more. ....One of my favourite quotations of Keynes is "It is better to fail conventially than to succeed unconventionally."PMy client needs 3000 lots of a Crack Spread Option (or as I mentioned below, you can make it as exotic as you want), I can't reduce the volume since thats what he wants! How do I statically hedge this option, I have no idea, do tell me! Charge the highest price I can get away with". Then there would be an offer war between me and JP! I'll keep offering it 1 cent lower than JP until I think that the risk is too much to handle, if JP gives up at a point where my premium for hedge error is a 1.5 STD (rather than a 2 STD), should I bail and let JP handle the risk for a 1.6 STD hedge error? Or should I still go the Commodity Regulators and complain about JP charging an unusually low price for the Derivative, how low is too low? I like the quotation of Keynes, so what he basically says is that "The brilliant guy sitting in his lab, waiting to overcharge for his derivatives and never getting any business is better off than a large investment bank who charges 'competitive' rates and makes money until a bust? Since in the end, both their total profits 'at some point' will a.s. hit 0. Only that the unconventional guy was paid by his shareholders and finally lost all their money. And the conventional guy never made any money in the first place? Really now, if we do not believe in calibration, how can there be a derivatives market? You can't even arrive at a fair value, unless you have a structural model for the underlying! Should there be a crackdown? Or any other viable ideas for making markets on exotics?You want to take on the business if you think you can do it sensibly. The first question mightbe "do you think you really understand your client's market?". If the answer to this is "yes", then presumably somemodels have already been built that at least are a basis for exploring the hedgibility of the exotic in question. Calibrating them and testing a hedging plan would certainly be an important step. I agree with Paul that the ultimate answer might be, for a particular client request, to say "no, we are not interested, at least at this time".But, calibration would/should certainly play a role in arriving at a putative "no". So, rather than hating on calibration, more useful would be a discussion on how to use it properly.
Last edited by Alan
on May 6th, 2011, 10:00 pm, edited 1 time in total.