The bid–offer spread

The standard prudent accounting methodology is to value long positions at bid, and
short positions at offer. However, what about positions between two trading desks,
which clearly have no overall profit effect, but will show a loss under the standard
policy? Then there are trades between two books within one trading desk, which may
have been entered merely to neaten up books but will cause a loss to be reported
until the positions expire. The obvious approach is to price all positions at midmarket,
which has justification if the organization is a market-maker. However, it is
unlikely that the organization is a market-maker in all the instruments on its books.
The answer to this is to price at mid-market with provisions for the spread. When
there are offsetting positions within the organization no such provisions are made.
The method of implementation of this policy has implications for accountability. If
the provisions are made at a level above the books then there is the problem that the
sum of the profits of the books will be greater than the total, which is a sure way to
arguments over bonuses. If the provisions are made at book level, then the profit in
a given book can vary due purely to whether another book closed out its offsetting
position.
A related point concerns volatility. As volatility is an input parameter for OTC
option-pricing models, for valuation purposes it should be derived as far as possible
from prices for traded instruments. However, there will be a bid–offer spread on the implied volatility. Should the volatility parameter be the bid–offer or mid implied
volatility? As with absolute prices the recommended approach is to use mid-market
with provisions for the fact that one cannot usually close out at mid. However, with
volatility, not only are the bid–offer spreads typically very wide, but there are the
extra complexities that the market is frequently one-sided and the volatility parameter
also affects the hedge ratios calculated by the models.