Swimming with Sharks

A lively discussion of the dilemmas quants face in the pricing of certain hard-to-value derivatives such as: ESOs (employee stock options), volatility swaps, volatility options, electricity derivatives, and barrier options with a volatility skew.

Rich Tanenbaum is asked to comment on the state of valuation techniques for electricity derivatives. "It's not like a bond, because there are lots of timing wrinkles," "... many people trading these products are possibly expert in electricity but not in derivative markets. This means an increased risk of devastating events."

Rich also makes remarks concerning the effect of volatility skews on barrier options. "Effectively one has to predict how the volatility of at-the-money options will change as the market moves," says Tanenbaum. "Some people maintain that the entire volatility surface will change, which means you need a model to incorporate that. Others say it will remain static and that arbitrage opportunities will result. I find it intriguing that, in the presence of a smile, if at-the-money volatility stays flat as prices move, you have out-of-the money options losing volatility as they get closer to the money, then gaining volatility as they get in the money."