Monday, July 2, 2012

IR exposure of a strucrtured vol dealer desk

I believe many (if not most) structured volatility contracts have some IR exposure. Forgive me for stating the obvious -- exposure is felt by both the sell-side and the buy-side, though either side can hedge away that exposure. Let's focus on the sell-side.

On a structured volatility dealer desk, I believe (confirmed by a veteran) the vol exposure outweighs any IR exposure, since the desk is experienced and set up to trade volatility, not IR. This means that interest rate fluctuations should have less PnL impact than volatility fluctuations.

However, the back office (including IT) must get the IR calc right, which is often non-trivial. Therefore to the back office employees, IR calc could be more complicated than the vol calc. For a given portfolio, I guess the business logic and processing complexity might theoretically be dominated by the IR component rather than the volatility component. This is suggested by anecdotal evidence.

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