Hi,As we all know there is a volatility smile (smirk) and in the real world options are priced according to this smile. As far as I know there is no unique way to define a volatility to price a certain option. The thing that I am wondering is that all major financial institutions are pricing over the counter fx options identically. Most of them are providing real-time implied volatilities for certain currency pairs and I observed that they all have the same implied volatility figures. But how?One posibility is that they are all using the same pricing model like Heston's and thats the reason why they have the same implied volatility. But Heston (or any other model) requires a lot of additional input (vol of vol, mean reversion etc.) which again brings me again to the question how they all get the same price?Another possibility (but I think the first is more likely) is that they have a unique way to derive the (implied) volatility...So in short how are they calculating these otc fx options so that they get the same result?

ok I understand the logic of this and I agree in general, but the vols (prices) are even identical in intraday terms and it seems unlikley to me that they are arriving to a unique price with arbitage trading like it is done for forex quotes. This may be true to fine tune the option prices but dont you think that they have a certian pricing model that leads to the identical volatility smile?

I hope someone who works in that area will answer. Idon't, but I can make some different guesses:(i) all the institutions where you asked for quotes were using a vendor's system that simply marks up an inside market to quote to a retail client. If they were all using the same vendor, this would explain it.(ii) all the real, inter-bank market action occurs at one more decimal point to the rightof what you were quoted. So, while the market is continually bouncing around at a certainlevel, there is still enough agreement over say a couple hours to quote you a common implied vol. at lower precision.(iii) if you aren't talking about executable quotes, but simply last trades, then most institutionsshould report something very similar or even identical at a given point in time, especially if they are just relaying info from one or two vendors. Like I said, it will be interesting to hear from an informed participant. Of course, maybea better route is to ask your trade/quote providers for the answer --- please post their response.regards,

QuoteOriginally posted by: enginkuruok I understand the logic of this and I agree in general, but the vols (prices) are even identical in intraday terms and it seems unlikley to me that they are arriving to a unique price with arbitage trading like it is done for forex quotes. This may be true to fine tune the option prices but dont you think that they have a certian pricing model that leads to the identical volatility smile?Why do you think it's unlikely? And when you say identical, do you really mean similar? I imagine that the published FX IVs (implied vols) supposedly represents the best bid and offer in the markets for the ATMs and the wings i.e. it represents a composite of the "market"'s volatility surface.Personally, I think those IV quotes are from those who actually bother to publish them. I suspect there's still a lot of price discovery being done in the background, what with the growing volumes from private banking flows.Even then, I still believe the net result of that background process will (somehow) filter back into the "composite" vol surface you see published on reuters or bloomberg...As for the pricing model, my impression is that banks just use the "standard" model to convert IV to premium, and not to derive the IV itself. Seems to me, IVs are quoted just like spot fx; i.e. there's not a lot of science about its practical derivation. To clarify: One year in, I'm a relatively junior entrant in the interbank fx options market. It's a new market for my organization as well. My main background is trading spot FX and swaps for the last 10-or-so years.

Here is some information I found got from one of the largest financial instutions."...(how) the volatility smile is incorporated in (...) risk management process isone of the frontier issues in the wizardry world of derivative research, as much among the practitioners as among the academics. However, since such information forms a core part of the trade secret for investment houses, it is not surprising to see that the information in the public domain is dominated by the academia.An option market maker will continuously quote (.....) reacting mainly to two sources of information, market conditions, and proprietary distribution assumptions and models"Doesnt that sound as if they are using a specific model that they are calibrating for market conditions and that the model is a secret. I think there should be some academic papers written about this. Any recommendations?ps:QuoteAnd when you say identical, do you really mean similarNot 100% the same but similar enough to arrive at the same price

In an active market like fx, they don't need a model beyond Black-Scholes in my opinion,to be a market maker. And they only need BS to turn prices into implied vols and vice-versa.It's no different than equities, for example, where you'd probably agree there's no 'model'.At this point, whether or not there is any puzzle at all is vague to me.You need to post some specifics: what -exactly- did you see that bothers you?Last sale prices, indications of prices, one/two-sided executable quotes or what? And quoted by whom over what time period?

There are ways to get a vol smile out of time series data for less liquid options (as long as you get a good time series for the underlying). This will then represent the fair vol based (at the strike) given the historical information. There is a variety of ways for doing this...all have their strong points and weak points. Also that vol then represents the lower boundary of what they vol should have been (for an option seller). So now you can add your own risk premium on top of that. It works quite well for either estimating vol for pricing in illiquid mkts or doing some sort of relative value trade in liquid mkts where you compare this fair vs the actual implied vol smile.

You guys are extrapolating from equities. In equities you see prices, which may or may not have been simulatenously traded on an exchange and then try to imply the vols used.In FX you dont make prices, you make vols. The prices are then computed using BS formulas for vanillas.It's easier to do it this way as vols do not have to be refreshed with every spot move. If you know the BS formula you can always compute the price youself. In a way it represents the slightly greater sophistication of the end user. There are people who want to know only the premium, and then waste your time asking for it to be refreshed with every spot move.

QuoteOriginally posted by: flairplayIn FX you dont make prices, you make vols. The prices are then computed using BS formulas for vanillas.Exactly. We normally use BS to convert IV to premium and not to derive the IV itself. Enginkuru: if your only concern is that banks are not transparent with their proprietary models, be prepared to be disappointed a little while longer! (*chuckle*)I doubt that banks like That Prominent Swiss Bank (whom you also quoted) would share their models or even be obliged to follow any specific academic recommendation. Ask 10 different banks, and they will show ten different vol surfaces for the same ccy pair, albeit for G7 currency pairs I imagine the shapes would look "similar" if only because they would have been "arb-ed" out in short order. Personally, the more intellectually interesting models are the ones that attempt to predict vols for exotic currency pairs like the USD/MYR. But practically, even THAT would still be a cr@pshoot most times. Sorta like trying to handicap a Premier League match or the World Cup.