April 11, 2024 (NO COMMENTS)

Julius Baer quant proposes novel way to generate accurate prices for illiquid maturities

Even the most highly traded derivatives can have illiquid points that create gaps in the implied volatility surfaces traders use for pricing. When those illiquid points are surrounded by liquid points, interpolation methods can be used to fill in the gaps. But for deep out-of-the-money strikes and long-dated maturities that are rarely traded, a reliable methodology for extrapolating prices is lacking, with traders often relying on crude approximations that are akin to rules of thumb. “The most used approaches to fill volatility surface gaps are those that use interpolation techniques based on local volatility models or Bayesian methods,” explains Andrea Pallavicini, head of equity, FX and commodity models at Intesa Sanpaolo. “But those are less suitable for extrapolations of prices at illiquid or non-traded maturities.” A conversation with traders at Julius Bear in Zurich prompted Valer Zetocha, a senior quantitative analyst at the firm, to search for a better solution.
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