What is best or generally accepted practice when it comes to checking front office marks for illiquid OTC instruments.For example, a trader may be right in saying that the 850 / 1250 broker quote for a 2y10y straddle in XYZ currency is Bullsh.... and not tradable. However, his recent purchase of 2y10y straddles needs to be marked to "market", and not marked to "wishful thinking by the trader", even when there is no active market. It sounds like a stupid question...I have been trading (liquid) options for years, but I never had to deal with the problem of illiquid markets. Recently, I have had numerous discussions on valuing illiquid options and it seems to me the traders in those markets are seriously disgusted by having a risk manager mark their books to broker mid quotes. I am seriously disgusted by a trader having full control over his own marks. So what is the solution?My opinion is that on any given day a broker quote may be off LOCALLY (within a range of where the market would actually clear), but over longer periods (say over a couple of weeks) broker quotes do represent the market (plus some noise). Hence they can very well be used to mark a trader's P&L independently of the trader. Much better in any case than having the desk put their own price tag on their own positions. Of course the trader can feed his own quotes to the broker, but again, he can only move prices locally (within a range of fair value) and not all the time. If he is off by too much vs the "fair" level, someone is gonna come in and do the trade (hedge funds, real money managers, other desks, etc). Don't even start the discussion on "what is fair anyways" with me (there is a level, above and below, at which anything trades, anything, even subprime equity tranches, so: end of discussion).So how is this problem solved elsewhere?

Protter and Jarrow have some technical papers on this - see their websites at Cornell:Liquidity Risk and Option Pricing Theory, to appear in the Elsevier Handbook of Financial Engineering. Liquidity Risk and Risk Measure Computation, to appear in Review of Futures Markets.HTHTJ.

Normally in places where I have worked there is a price verification process that takes place every month and is performed by an independent unit (i.e. Finance) - however I know that the process falls down as more than once I have been places where desks have had to take a hit due to someone realising they were marking incorrectly.

career wise, it's probably better that you just let this go. you may win the battle, but you will lose the war. they will talk shit about you and spread all sorts of lies and rumors to the rest of the front office people and your managers. they will say that you're stupid and incompetent and you don't understand trading.if you are in a position of power and you believe that these people are just inflating their pnls to show that they're profitable traders, simply take a liquidity discount of maybe 15% off their marked price. no fancy academic paper is going to tell you how to accurately take this liquidity discount.

QuoteOriginally posted by: quantnewbcareer wise, it's probably better that you just let this go. you may win the battle, but you will lose the war. they will talk shit about you and spread all sorts of lies and rumors to the rest of the front office people and your managers. they will say that you're stupid and incompetent and you don't understand trading.I have been around long enough to know that this is indeed what happens. Traders LOVE to intimidate non-traders by claiming that there is a certain mysticism that surrounds their activity, and only the chosen few who do trade do know the secrets. Trust me, most of the time that is complete BS, and its sole purpose is to defend the turf from intruders. Like a dog peeing on a pole, pretty much.My interest is in how other banks ensure that their traders don't pull this shit. It is very easy for a senior trader to intimidate the hell out of some junior performance analyist who asks questions....Are there ways to independently and objectively mark an OTC book. Hedge funds and buy side portfolios are all independently valued, for example. This separation of duties does not seem to be widespread on the sell side.

Apologises Quantnewb, I'm afraid I must strongly disagree with you.Most back and middle office failures that result in a negative (and yes, positive...) P&L events are the result of lax controls and are usually accompanied by a lack of understanding of how front office actually generate their revenues. (I will provide plenty of examples if you wish)Whilst it is admirable to want to maintain a good working relationship with front office and want to progress you primarily have a responsibility to conduct your business professionally and prudently.if GMike is "in a position of power" then I presume he'd have an understanding of the workspace or atleast have the resources to find out the information he needs to. In that case it is his responsibility to highlight your concerns to the appropriate parties (whether that's head of trading, finance, controlling, audit etc etc).If he's not "in a position of power" then I would suggest it is his responsibility to escalate this to his manager, listing the concerns and asking for this to be addressed. Although this does not absolve all responsibility it would highlight the issue to management and in any decent bank atleast, they'll be expected to pick it up.Ofcourse, I don't really know GMike's exact situation or role but I agree with him that traders should not be allowed/ are not able to determine their marks objectively and it is his job to not be intimidated by the traders and to provide an adequate level of control.End-rant -> To respond to GMikes original question:When I worked at a hedge fund we priced our own OTC's and took month end MtoM values. We ticked these back and any large discreps were identified by accountants based in back office (outsourced) and we'd query our model and then speak to client services at the bank we traded with.Now I work in a large investment bank, here we have a risk team that runs it's own seperate pricing models across all products. We then run P&L reports at month end and try to identify discrepancies. This isn't the only control we use, but it's one of them. We certainly don't ask our traders to provide prices for us. I'd rather ask the cleaner to be honest.

Raise High the Roof Beam, Carpenters

In principal, all one needs is good quality data from the FO. The rest (pricing) one should be able to do independently oneself using the best models available. Herein lies the challenge - which models does one use?

all the banks work the same way and hedge fund portfolios are not independently valued. there is only one way to properly mark anything - use the market price. if the market is illiquid then use a liquidity discount. the liquidity discount will not be perfect. sometimes it will undervalue the security, and sometime it will overvalue the security. so what? the point is to be conservative and make sure the pnl that's reported in the books isn't higher than the actual pnl, whatever that may be. when the trader exits his position, you will have the realized pnl. if this realized pnl is larger than the marked pnl, so what? his pnl will now be adjusted to reflect the realized pnl.QuoteMy interest is in how other banks ensure that their traders don't pull this shit. It is very easy for a senior trader to intimidate the hell out of some junior performance analyist who asks questions....Are there ways to independently and objectively mark an OTC book. Hedge funds and buy side portfolios are all independently valued, for example. This separation of duties does not seem to be widespread on the sell side.

c'mon, all of this is complete bs and doesn't resolve anything and you know it.QuoteWhen I worked at a hedge fund we priced our own OTC's and took month end MtoM values. We ticked these back and any large discreps were identified by accountants based in back office (outsourced) and we'd query our model and then speak to client services at the bank we traded with.Now I work in a large investment bank, here we have a risk team that runs it's own seperate pricing models across all products. We then run P&L reports at month end and try to identify discrepancies. This isn't the only control we use, but it's one of them. We certainly don't ask our traders to provide prices for us. I'd rather ask the cleaner to be honest.

Here's my 2p. Market Data should be independently sourced by Middle Office, the Front Office can provide guidance as to where to get it from but the responsibility for independent marks (and accounting records) rests with Middle Office. Middle Office should then use their own approved models for the calculation of derivative pricing.If the business is operating in an illiquid area it is in everybody's interest to ensure that there is no "blow up" on the horizon. Things you can look at are proxies, reserves (based on some sort of risk measure e.g. 1 Vega etc) or some sort of parametric fitting (although this can be bs more times than not). Certainly for key accounting dates you should request third party quotes and this may mean paying some sort of market data provider to get them (if the position is large then I would argue this is a worthwhile cost to the business).On a separate note, does an illiquid position constitute a trading book position? The reason why I ask is that one of the traditional definitions of a trading book is a constant turnover of positions (30-90 days I think). Most organisations have policies for dealing with these types of situations and if they don't then the situation should be escalated asap.QuoteOriginally posted by: Gmike2000What is best or generally accepted practice when it comes to checking front office marks for illiquid OTC instruments.For example, a trader may be right in saying that the 850 / 1250 broker quote for a 2y10y straddle in XYZ currency is Bullsh.... and not tradable. However, his recent purchase of 2y10y straddles needs to be marked to "market", and not marked to "wishful thinking by the trader", even when there is no active market. It sounds like a stupid question...I have been trading (liquid) options for years, but I never had to deal with the problem of illiquid markets. Recently, I have had numerous discussions on valuing illiquid options and it seems to me the traders in those markets are seriously disgusted by having a risk manager mark their books to broker mid quotes. I am seriously disgusted by a trader having full control over his own marks. So what is the solution?My opinion is that on any given day a broker quote may be off LOCALLY (within a range of where the market would actually clear), but over longer periods (say over a couple of weeks) broker quotes do represent the market (plus some noise). Hence they can very well be used to mark a trader's P&L independently of the trader. Much better in any case than having the desk put their own price tag on their own positions. Of course the trader can feed his own quotes to the broker, but again, he can only move prices locally (within a range of fair value) and not all the time. If he is off by too much vs the "fair" level, someone is gonna come in and do the trade (hedge funds, real money managers, other desks, etc). Don't even start the discussion on "what is fair anyways" with me (there is a level, above and below, at which anything trades, anything, even subprime equity tranches, so: end of discussion).So how is this problem solved elsewhere?

I think that's fair.Although (IMHO) an illiquid OTC trade held for a long period should still normally be classified as a trading book position, because no matter how long you choose to keep it on your books it may require regular hedging. Plus in any given month, there is always the POSSIBILITY that it might get traded out or have a corresponding position booked against it. Most traders will have other trades in their portfolio and need to consider net position and risk, so it is still part of the their book.

By that logic one could use uncertain paramater approach for valuing the illiquid OTC trade?QuoteOriginally posted by: leehayes81I think that's fair.Although (IMHO) an illiquid OTC trade held for a long period should still normally be classified as a trading book position, because no matter how long you choose to keep it on your books it may require regular hedging. Plus in any given month, there is always the POSSIBILITY that it might get traded out or have a corresponding position booked against it. Most traders will have other trades in their portfolio and need to consider net position and risk, so it is still part of the their book.

Does the "uncertain parameter approach" only assume the extreme negative results? (I don't know much about it but just googled it quickly and it looks a bit like stress-testing to me).If we started valuing OTCs using the worst-case senario everytime nobody would ever trade!!

oh really? what's the trader afraid of? when he exits the position he will have the realized pnl which will show definitively whether he made money, right?QuoteIf we started valuing OTCs using the worst-case senario everytime nobody would ever trade!!