Derivative finance: Encyclopedia II - Derivative finance - Valuation

Derivative finance - Valuation

Derivative finance - Market price and Fair value

Two common measures of value are:

• Market price, ie. the price at which traders are willing to buy or sell the contract
• Fair value or the Theoretical price, ie. a rational and unbiased estimate of the contracts fundamental value

Derivative finance - Determining Market Price

For exchange traded derivatives, market price is usually transparent (often published in real-time by the exchange, based on all the current bids and offers placed on that particular contract at any one time).

Complications can arise with OTC or floor-traded contracts though, as trading is handled manually, making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to collate and disseminate prices.

Derivative finance - Determining Fair Value

The the fair value of a derivatives contract is often complex, partly because of the immense variation in contracts, and partly because there are often many different variables to consider.

Fair valuation of derivatives is a central topic of financial mathematics. Where "fair" refers to the absence of arbitrage, meaning that no riskless profits can be made by trading in assets. Crucial to the valuation of derivatives is also the stochastics of the underlying assets, typically expressed as a stochastic process.

A key equation for the theoretical valuation of options is the Black-Scholes formula, that made it possible to replicate a stock option by a continuous buying and selling strategy in the plain stock. Other derived equations include the Binomial options model, Kim and Garman-Kohlhagen models.

Adapted from the Wikipedia article "Valuation", under the G.N U Free Docmentation License. Please also see http://en.wikipedia.org/wiki