Hi there!I hope someone can advise me on mark-to-market caplets given the caplets market is underdeveloped. How do I model the volatility term structure for the caplets using historical data? Regards, Cassidy

The caplet market is actually very well developed. Out for the first few years, you can get good volatilities from eurodollar options. Beyond that, you can bootstrap off caps, which are pretty liquid.If you develop a surface which prices caps correctly, then it also prices caplets correctly.One minor point to note is that there is often a difference beween the vol of eurodollars, and of the corresponding caps. It is of the order of up to one lognormal vol.

QuoteOriginally posted by: NorthernJohnThe caplet market is actually very well developed. From looking into his info, he is in Malasia, so his caplet market might not be well developed. I don't really know what to do in that case, but maybe use historical GARCH vol and add a real fat premium for implied/realized vol risk. Did i mention a real fat premium?

QuoteOriginally posted by: NorthernJohnOne minor point to note is that there is often a difference beween the vol of eurodollars, and of the corresponding caps. It is of the order of up to one lognormal vol.Hi all, could NorthernJohn or someone else develop on the quote above, Cheers all.

QuoteOriginally posted by: EngMoiQuoteOriginally posted by: NorthernJohnOne minor point to note is that there is often a difference beween the vol of eurodollars, and of the corresponding caps. It is of the order of up to one lognormal vol.Hi all, could NorthernJohn or someone else develop on the quote above, Cheers all.In major western markets (USD, EUR, GBP), it is frequently the case that exchange implied volatility is noticeably different to OTC implied volatility. This means (given the fact that caplets and futures fix off the same index) that it is a common relative value trade to sell exchange options, and buy OTC options.It's a long way from arbitrage, as you get some quite unpleasant exposures when a future rolls off.To go back to your original question, and risking speaking at too simple a level for you (apologies if this is something you already know), you need to remember that implied vols will tend to be higher than historic vols, as implied vols take account of very rare events (tokyo falling into the sea, world war III, all governments converting to Islam and banning interest payments) that haven't recently happened.There is then the difference caused because future predictions of volatility do not necessarily match historic volatilities. What you could perhaps do is look at the long term (10 years) difference between historic and implied vols for a currency like USD, and use this as your starting estimate for implied vols for your own currency. It's a long way from perfect, but should be a decent starting point.If you have a developed swaption market, and you have some reasonable ideas about correlation between the various forward rates, you can also look at what the swaption vols imply for caplet vols.

QuoteOriginally posted by: slevinQuoteOriginally posted by: NorthernJohnIn major western markets (USD, EUR, GBP), it is frequently the case that exchange implied volatility is noticeably different to OTC implied volatility. This means (given the fact that caplets and futures fix off the same index) that it is a common relative value trade to sell exchange options, and buy OTC options.Has to do with the settlement rules and some other "minor" things - the closer you get to expiry, the more pronouced the difference is. In fact, P/C parity might not hold for exchange traded ED and Note/Bond options because of the settlement rules.Would you care to explain that, with respect to eurodollar calls and puts, against short dated caps?What settlement ruiles and "minor things" are you referring to?

main problem w. being short on exchange vis a vis OTC is problem of pin risk.OTC, you know whether you have been exercised (just) prior to expiry; on exchange, you wait for expiry, and then the assignment process, and then for your clearer to communicate the results of the assignment ---> much more significant pin risk

QuoteOriginally posted by: andymmain problem w. being short on exchange vis a vis OTC is problem of pin risk.OTC, you know whether you have been exercised (just) prior to expiry; on exchange, you wait for expiry, and then the assignment process, and then for your clearer to communicate the results of the assignment ---> much more significant pin riskthat was also mentioned, i forgot to add it in.

QuoteOriginally posted by: slevinQuoteOriginally posted by: NorthernJohn What settlement ruiles and "minor things" are you referring to?Disclamer: Not having really dealt with these myself, I am just regurgitating what was explained to me by traders who work in that market. The following reasons that were explained to me area) Convexity-related advantages for put sellers and call buyers in delta hedging with a futured contract, vs disadvantages for put buyers and call sellers.b) In advance settlement on futures vs in arrears settlement on OTC caps/floors c) Tick size settlement for ED futures options - sellers have a tendency to "round-up" the riskd) No performance bond required for put or call option buyers, (just the premium must be paid in full) while option sellers must meet additional performance bond requirements.Thanks.I used to trade this stuff, and had thought you were maybe suggesting that the difference was only apparent, not real. It was, in general, pretty profitable business, with the occasional bad day when I was left very short gamma in my stub rate.In the period I dealt, the common trade was to sell OTC, and buy ETO. If this was put on in several million per lognormal vega, it produced good returns in the time I was involved.