80 Frequently Asked Questions In Quantitative Finance
to be, or the profit you expect to make. After all, you
presumably entered the trade because you thought you
would make a gain.
Hedge funds will tell their investors their Net Asset
Value based on the mark-to-market values of the liquid
instruments in their portfolio. They may estimate future
profit, although this is a bit of a hostage to fortune.
With futures and short options there are also margins to
be paid, usually daily, to a clearing house as a safeguard
against credit risk. So if prices move against you you
may have to pay a maintenance margin. This will be
based on the prevailing market values of the futures
and short options. (There is no margin on long options
positions because they are paid for up front, from which
point the only way is up.)
Marking to market of exchange-traded instruments is
clearly very straightforward. But what about exotic or
over-the-counter (OTC) contracts? These are not traded
actively, they may be unique to you and your counter-
party. These instruments have to bemarked to model.
And this obviously raises the question of which model
to use. Usually in this context the ‘model’ means the
volatility, whether in equity markets, FX or fixed income.
So the question about which model to use becomes a
question about which volatility to use.
Here are some possible ways of marking OTC contracts.
- The trader uses his own volatility. Perhaps his best
forecast going forward. This is very easy to abuse, it
is very easy to rack up an imaginary profit this way.
Whatever volatility is used it cannot be too far from
the market’s implied volatilities on liquid options with
the same underlying.
