OTC Instrument Pricing
There are many differences between ‘Exchange Traded’ and ‘Over The Counter’ products, but one of the most significant would have to be pricing model transparency. When purchasing shares, financial futures or share index options, the contracts are clearly defined including the models and techniques use to calculate a fair value price. It is of course different views of the market and different situations of the participants that ensures a healthy exchange traded market continues to exist.
While Over the Counter (OTC) markets are also driven by similar factors, there is an added challenge to buying or selling instruments this way. This is the challenge of pricing them. There is essentially no set rule as to how to come up with the ‘correct’ price for most OTC traded instruments, and even the definition of correctness can be argued. Is it correct to be consistent with other markets or consistent with other brokers? Take Forward Rate Agreement (FRA) pricing for example. A FRA could be looked at as a single interest rate swap roll, and you could use the curve construction and interpolation techniques common in swap markets to derive an implied forward rate to serve as a basis for your FRA. However this would be inconsistent with the techniques used in the FRA market, where linear interpolation between futures contracts is the accepted method of deriving a rate.
The situation becomes even more complicated when you consider complex derivatives which feature many legs, optionality and underlying rates linked to various other markets. For many of these instruments, there simply isn’t a ‘correct’ way to price them. Each institution will make their own decisions as to the methods and models that they use.
So how can you know you are being quoted a ‘fair price’ for a derivative? Well, you could phone around all the banks and brokers offering such a derivative and find the average, high and low price – but what does this tell us?
We must consider that the sell-side institutions will be quoting a two-way price, so no matter what you do with a collection of offer prices, you will not be seeing fair value. The prices being quoted include margins, a fee for service usually not disclosed by the seller. You could take into account bid prices too, and average the bid and offer prices for each institution to find a mid price, then average these mid prices. Will this give us fair value? Probably not.
The first thing to consider is that a two-way price on a structured OTC derivative may be hard to come by. Unless you can price these yourself, you will be limited to calling a bank and asking them to quote you a price based on the trades individual attributes. Once the bank crunches the numbers and offers to sell you the derivative, you won’t be popular if you ask for a two-way price (it will be pretty obvious what you are trying to do). The other thing to consider is that margins are not always symmetrically added around a fair value. A margin is likely to encapsulate not only the broker’s fee in performing the transaction, but also their current position in the market, hedging costs and their ‘aggressiveness’ in writing such business. To hedge a trade in a cash market, for example, a broker may have different borrowing and lending costs, which may skew the bid/offer price.
So let’s assume that we can price this complex (or just tailored) derivative ourselves. If we can calculate fair value, what does this mean when shopping around for a deal? There are three benefits.
Firstly, if we can price the instrument ourselves, we can get a fair idea as to what to expect. We may find that a particular hedge or speculative trade is not feasible even before we phone the banks. We may chose to ‘play’ with the structure a little, raising an option strike for example to provide a better cost/benefit equation. To do this kind of fine-tuning over the phone is more cumbersome and time-consuming.
Secondly, we may be looking for an indicative price, say to add to a hedging proposal to management. Calling the sell-side institutions for this information exposes your thinking in advance. You may not want to show your cards until you are ready to trade.
Thirdly, and perhaps most importantly, knowledge is power. If you are being quoted a price by your bank, and you can judge the level of margin on this trade, then you are in an informed position. Whether this translates to any more negotiating power is influenced by a number of factors, including the size and risk level of the trade and the relationship with the bank, but you will be able to verify where fair value lies, and make a decision that includes that information.
The expectation here should not be that independent pricing will squeeze away margins. There will always be margins on trades, if there were not, no-one would be offering to sell you a derivative. Margins will always be steeper for less vanilla trades too, as there is more complexity in continuously hedging and managing risk on that trade throughout its life. While you cannot reasonably expect to offload risk without paying for the privilege, you should expect to be able to calculate what you are paying.
