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ithousekeeper
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Posts: 33
Joined: March 28th, 2009, 11:09 pm

At-the-money Vols. Why?

April 17th, 2011, 8:48 pm

Our system constructs a volatility surface using ATM caplet and swaption vols. At the end of the trading day, our system also saves the closing ATM caplet and swaption vols for risk processing.Can someone tell me why ATM vols are important? Who do traders not care so much about out-of-the money vols?
 
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DocToc
Posts: 239
Joined: January 20th, 2010, 9:32 am

At-the-money Vols. Why?

April 18th, 2011, 7:09 pm

atm volatility is what option traders trade most of the day. They are liquid. Skew is important and can contribute a significant amount of PnL as well but isn't very liquid i.e. you wont find 200 out payers too easily. Also delta is very sensitive to changes in atm volatility (probably more so than changes in the skew) - this concept is called normalised delta. Further, skew is normally a function of atm vols so how atm vols change defines (given whatever model you have calibrated to interpolate your skew due to lack of liquidity) how the skew will change. So getting atm's is very important. Lastly skew is important too but you cant expect someone to know how the whole skew is evolving at any point in time instead atms given your interpolation or model provide a nice summary of what is happening to skew. the traders who dont care too much about of OTM vols are either (a). Not too sharp.(b). Have very little skew risk so aren't too bothered about OTM/ITM vols.Another big reason is that when pricing requests come in for a flow desk they are usually for ATM stuff (not to say that they aren't for OTM stuff but quite a few are for ATM stuff) therefore it is essential that you are marked correctly on ATM vols. Obviously that said if you are trading exotics like CMS swaps it is also essential that you are well marked on OTM/ITM vols too or you are going to mispricing stuff but still I'd say ATMs are more important.There are probably a hundred more reasons why atm vols are important.
Last edited by DocToc on April 17th, 2011, 10:00 pm, edited 1 time in total.
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