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fair price

d.koutsomito

Joined
7/22/13
Messages
43
Points
18
Hello everyone,

I have a question which may seem trivial to you.

Which is the difference between the fair price and the interval of prices observed in markets (bid-ask)?

What I mean is when someone wants to price a derivative and finds its fair price, e.g. European call, how he uses this price in order to sell the derivative. As far as I know, fair price and price observed do not coincide, am I correct?

I am looking forward to your replies.

Thank you.
 
Yes, you're right. From what I've learnt, the observed prices takes into account:
  • inventory costs
  • transaction costs
  • taxes
  • Risk of the financial institution making that quote
Everyone's fair price is different. To me, the fair price is the last traded price, but that could have happened many ticks ago.
 
Fair price is an unobservable quantity and is model-dependent. What happens is that a bunch of market makers (I'm assuming the market for the security is dealer-driven here) have their own independent judgement of what the fair value is. These market-makers will make spreads where the bid is lower than the fair price and the ask is higher - this needs to happen for the dealer's EV to be positive. Then the highest bid and lowest ask serve as the bid-ask that you observe. However, markets are competitive and to an extent dealers are price takers, so this keeps bounds on how high this spread can be. With that said, the spread will never be 0 because the market makers need to be adequately compensated for the risk of the security (higher the vol, higher the spread).
 
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