What's your market?

Traders get asked this question all the time. There is a certain pride in being able to make a market in something hard to price, to demonstrate a deep understanding of value and valuation.

But the probelm overshadowing any market making activity is that once a trade is done, it needs to be marked. And the real bid offer spread on any trade is a dynamic, breathing and living animal, waiting to rip the pnl away from the books if given a chance.

On top of that volatility of bid offer spread, we need to overlay a heavy blanket of regulatory requirements. A myriad of regulators and regulations require stringent adherence to a complex set of rules, especially those relating to prudential valuation practices, conjured up in the long shadow of the global financial crisis.

Thus now, for example, the Bank of International Settlements has published an entire book on guidance for valuation teams (https://www.bis.org/basel_framework/chapter/CAP/50.htm).

One important part to note is that bid offer is one of the key mentioned factors to be taken into account:

"These factors may include, but are not limited to, the amount of time it would take to hedge out the position/risks within the position, the average volatility of bid/offer spreads, the availability of independent market quotes (number and identity of market-makers), the average and volatility of trading volumes (including trading volumes during periods of market stress), market concentrations, the ageing of positions, the extent to which valuation relies on marking-to-model, and the impact of other model risks not included in CAP50.11"

Volatility of bid/offer spreads, volatility of trading volumes. These two factors alone can cause heartburn and worried faces at each month and quarter end. How do you even measure the volatility of bid offer spreads for something which trades once or twice a quarter? And what is the right way to compute bid offer spreads, given for example, exotic derivatives may not always be booked at the same time as execution date.

Here at PriceVault, we have spent most of our time studying and solving exactly these problems. Our clients use our bespoke data across IRS, Swaptions and other asset classes for bid/offer spreads, volume, and the volatility of each over time. We publish an index of liquidity, and an index of bid offer spreads which is helpful to identify regime changes for pruval and for risk measurements.

How do you measure bid/offer volatility for your pruval? Get in touch and we can grab a coffee to discuss!