A Front Office and Risk Management Tool for Pricing OTC Derivatives

In this paper we propose a proxy for the implied volatility of OTC equity derivatives. Our methodology rests on two pillars: (1) we exploit the information embedded in the price of the underlying asset by combining two measures of price volatility (2) we pool the stocks by sector in order to make a better use of their common features. After estimating a relationship between implied volatility of traded options and traditional risk measures using a set of panels, we are able to test the model performance both in sample and out of sample. We show that using our volatility measure leads to considerably more accurate pricing results than those obtained using the RiskMetrics only.