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FX Derivatives Trader School by Giles Jewitt

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Chapter 7Vanilla FX Derivatives Pricing

This chapter introduces two primary responsibilities of a vanilla FX derivatives trader: maintaining volatility surfaces and quoting vanilla price requests.

Maintaining Volatility Surfaces

In some financial markets, all relevant market prices can be observed directly in the market. However, in OTC (over-the-counter) derivatives markets, prices are very often requested for contracts that have not been directly observed in the market. This flexibility is a key advantage of the OTC market structure.

To quote consistent vanilla option prices for any expiry date and strike, traders keep a volatility surface updated in each currency pair. Exhibit 7.1 shows a three-dimensional representation of the volatility surface in one currency pair.

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Exhibit 7.1 Example volatility surface

The volatility surface can be split into two components: the ATM (at-the-money) curve and the volatility smile.

ATM Curve

ATM contracts are the backbone of the volatility surface; they define the term structure of implied volatility. ATM contracts are vanilla contracts quoted to a specific maturity and they have a strike near (or at) the forward to the same maturity.

ATM contracts are the most important price reference points within the FX derivatives market. In the interbank broker market ATM contracts are often quoted in a run of prices at the market tenors, the ...

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