Should a sophisticated model like local vol be for pricing futures and vanillas?

[themarketprofessor]

This is the thing, that formula is a simple price that tries to avoid arbitrage. And, since the replication of a forward contract is trivial, there is no need to assume a model for the underlying.

Ie, even if it is GBM, Heston, or some jump process, that formula still holds.

Of course, the big issue here is r and \(\delta\). Those aren't simple numbers to obtain.

Diego, why does futures price differ to FRA's?

 

[diegosanaz]

I have not studied enough on the subject to give a good answer. So what I say might not be precise:

From my understanding, for interest rates, the margin set up (futures) v.s. the settlement of expiration setup (FRA) calls for a convexity adjustment. Also, there might be some differences from the fact that forwards carry credit risk.

 

[themarketprofessor]

I have not studied enough on the subject to give a good answer. So what I say might not be precise:

From my understanding, for interest rates, the margin set up (futures) v.s. the settlement of expiration setup (FRA) calls for a convexity adjustment. Also, there might be some differences from the fact that forwards carry credit risk.

That was a very good answer to me, directly straight from your own observation which does not require a model or formula. Just be careful when you want to use a model/formula for any calculation because there are many assumptions under any models/formulae, whereas your own intuitions and observations are true measures of what going in the markets.

Beware of explanations and formulae in textbooks, don't be a slave to those models/formulae which are often misleading.

Do you observe that the FRAs and Futures are two separate markets which operate quite independently?

Given that theorectical payoffs of FRA and Futures are the same at maturity, and there are vanillas on FRAs and vanillas on Futures, the question is: Should the prices of these vanillas be the same?

 

[diegosanaz]

As I said, I can't give an educated answer, just an intuitive guess. But I'd say that FRA's have to be cheaper due to higher credit risk.

 

[themarketprofessor]

As I said, I can't give an educated answer, just an intuitive guess. But I'd say that FRA's have to be cheaper due to higher credit risk.

In the markets intuition wins the day! Yes FRA used to be cheaper before the 2008 crisis because there was negligible credit risk attached to it. After the crisis, credit risk component is attached to all FRAs. This makes values of FRAs relatively on par with Futures.

 

[Vinayak Maheswaran]

Let me make this really simple. Buy this book and read it.
http://www.amazon.com/The-Volatility-Surface-Practitioners-Guide/dp/0471792519

Good recommendation indeed!

 

[Vinayak Maheswaran]

In the markets intuition wins the day! Yes FRA used to be cheaper before the 2008 crisis because there was negligible credit risk attached to it. After the crisis, credit risk component is attached to all FRAs. This makes values of FRAs relatively on par with Futures.

This is a good observation..