Real World vols vs. Implied vols

[rainer.lux]

Hi David


just a brief question: In the European Energy markets (Gas and Power) the implied vols for options are about 400 to 700 basis points about the realized vols. I discussed this with a colleague from the finance sector recently and he thought that this is not due to counterpart Risk but only to market liquidity risk.


To confirm it, he stated that financial options with high market liquidity have very low spreads between the real world and the implied vol. Is this true? Clearly, market liquidity premium is one part of the CVA but does is the counterparty risk in OTC transaction affects the prices? Do you have any statistics about the contribution of liquidity and counterparty risk to the CVA?


David, I appreciate your answer and with best regards

Rainer

 

[ShaktiRathore]

hi,
The options high implied volatility Vs real world (the high risk premium) is due to both the market liquidity risk and counter-party risk. Your friend does indeed confirm this because once market liquidity risk premium is almost null(highly efficient markets) then what remains is the counter-party risk which accounts for the low premium.
Yes counter-party risk plays a big part in CVA valuation, a higher counterpart risk increases the CVA but a lower counter-party risk decreases the CVA. In sense counter-party's credit risk plays important part in CVA valuation. Liquidity has almost nil significance in CVA but counter-party risk/credit risk is the main risk we are concerned in the CVA adjustment. So stats(my view) is liquidity 0% and counterparty risk 100%. CVA measures the magnitude of counter-party risk and adjusted to party's credit.
thanks