Vanilla option contracts are priced using a volatility surface that returns a midmarket implied volatility for a specific maturity and strike. A bid–offer spread is then applied around the mid-rate to get a two-way price quoted in implied volatility terms. Exotic option pricing works differently. Exotic contracts cannot be priced directly off a volatility surface because they have additional parameters (e.g., barrier levels) and therefore a more generic approach is required.
Exotic option contracts are priced in premium terms and the pricing is anchored by Theoretical Value (TV)—the CCY1% value of the exotic contract under Black-Scholes assumptions, specifically:
The ATM volatility to the final expiry date is used for calculating TV on exotic contracts. This volatility is often taken directly from the desk volatility surface. When calculating TV on an exotic contract it is vital that the correct ATM volatility is used. In practice this means the exotic trader checking the validity of the desk ATM curve with the appropriate vanilla trader or with interbank brokers prior to pricing.
After calculating TV, the market price is then quoted as an adjustment to TV that takes into account all relevant factors not included within the Black-Scholes framework. This is called the TV adjustment. It is quoted in CCY1% ...