How does Derivative valuation work?

In this article, we will discuss the derivative market and its nature, including futures, swaps, options, and forwards.

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The derivative market provides a platform for traders with the opportunity to trade financial instruments that are based on underlying securities. The instruments are usually in the form of options, futures, swaps, and forwards. With the rise of digitalization, the ease of transaction, the growth of the derivative market, and other factors have dramatically increased, making derivatives an important channel for investors or traders to manage their risks and optimize their profits. In this article, we will discuss the derivative market and its nature, including futures, swaps, options, and forwards. Additionally, we will discuss how derivative valuation works. Let us get started!

Derivative contracts and their valuation

A derivative market is a type of financial market that uses derivative instruments based on some underlying assets. Investors or traders use financial derivatives to either hedge financial risks or to speculate on the price appreciation or depreciation of the underlying assets. In recent years, the amount of financial information being produced digitally has increased knowledge and data availability leading to more active derivative trading.

People can now access information and data more freely, which has greatly contributed to the growth of the derivative market. The derivative valuation usually relies on the underlying asset’s price and the current market value. Fluctuations in the price and volatility of the underlying asset, along with the market forces, can result in drastic changes in the derivative’s value. What are derivatives?

What are derivatives?

The term “derivative” refers to a securitized contract based on or derived from an underlying asset. Financial derivatives are revolving, highly portable instruments traded between counterparties based on their value. Derivatives include financial instruments such as forwards, futures, options, and swaps. These derivatives are designed to allow traders to manage the risks associated with price movements or volatility of an underlying asset and, as a result, to optimize the return on their investments.

Typically, the underlying asset is a security that can be indexes, stocks, currencies, commodities and so on. While trading in derivative markets either takes place on exchange platforms or over-the-counter (OTC), depending on the type of the financial instrument. Thus, strategies and proper analyses in order to hedge risk or generate higher returns can be implemented by traders through these financial instruments.

Types of derivative contracts

Now, let us continue to discuss the various types of financial derivatives. Following are some of the most common types of derivatives:

Options – An option is one of the most basic derivative contracts. An option contract allows the owner to either buy or sell a particular asset at a specific price on or before a certain date. The purchaser of an option has the right, but not the obligation, to buy or sell the underlying asset at a particular price. While the strike price is the price at which an option buyer has the right to execute the contract. It is essential to note that the options must be executed within the specified time window; if not, they will be considered void. In addition to this, call option and put option are two such terms used to describe the right to buy and sell, respectively. In other words, a call option is the right to buy, while the put option is the right to sell.
Future – A future contract is an agreement between two parties to buy or sell a specific commodity asset or security at a predetermined price on a specific date in the future. Typically, these contracts are traded on exchanges, and they usually have maturities for a maximum of 3 months. Futures are generally used to hedge the price movement of commodities or securities positions. It is important to note that trading in futures involves obligations making it mandatory for the trader to fulfill the contract upon future date.
Forward – The forward contract is similar to a future contract. A forward contract is an agreement between two parties who agree to buy or sell an asset at a predetermined price on a specific date in the future. However, unlike futures, forward contracts are not traded through exchanges. As a result, there is no central clearing house that ensures that the transaction will be carried out on the specified date. Furthermore, the forward contracts can be tailored to meet the specifications of the particular trader.
Swap – A swap is an agreement between two parties to exchange a stream of cash flows or liabilities over a period of time from different financial instruments. Usually, swap trading is based on loans or bonds and is traded over-the-counter (OTC). Swaps are typically used to manage the interest rate exposure on the underlying asset. The dealer who offers the swap pays a fixed rate or a floating rate to exchange the interest rate exposures. The deal between the two parties is generally a risk transfer contract that allows one party to transfer from one instrument to another.

Uses of derivative contracts

Derivatives can be used to manage and control risk exposure, or they can be used to generate portfolio income. Investors can use financial derivatives as a way to position their portfolios based on the market and economic conditions. Here are some of the most common uses of derivative contracts:

Market volatility protection – Market volatility protection is a hedging strategy in which a trader can use a derivative contract to reduce the exposure of risk in the market. Traders can use derivative instruments to offset their stock holdings by hedging their positions. Thus, the most common use of this strategy is to lock in long positions and reduce the exposure to market volatility.
Park surplus funds – The technique of parking surplus funds is employed wherein the trader can take advantage of price fluctuation without selling the underlying asset. As a result, traders can boost their profit from the price fluctuation.
Arbitrary advantage – Arbitrary advantage is a method in which traders buy or sell financial derivatives at a lower price from one market and thereby sell the same derivative at a higher price in another market. The two markets should be entirely independent and separate from each other.

Pros and cons of derivatives

With the advent of financial derivatives and their proper use in the capital market, market participants started considering them as a major source of value. However, traders have to be cautious in order to avoid the pitfalls of derivatives. Following are some of the most common pros and cons of derivatives:

Pros

Financial derivatives allow traders to tap into new markets, which otherwise would not be possible. The ability of derivatives to hedge against rapid market fluctuations and minimize risk exposure allows investors to diversify their portfolios. As a result, they can get access to different markets with different risks and return opportunities.
A trader can minimize risk by taking a position in a different market with a different risk profile. As such, derivative instruments allow investors to increase their profit potential by lowering the risk in the market.

Cons

The risk of financial derivatives is inherent in the nature of the market. Every day traders should avoid investing in derivatives as they can be risky. It is very important for traders to become aware of the risks and rewards associated with derivative markets in order to use them effectively.
Derivatives are not easy to understand. Therefore, investors have to gain a full understanding of the derivative market before trading in financial derivatives. They are complicated in the sense that different market segments require completely different definitions for the same instrument.

Derivative valuation

The fair value of a derivative instrument is deemed to be the price at which it can be expected to be exchanged between two parties. More specifically, fair value is determined by reference to a framework of inputs and assumptions, which are future cash flows, the present value of future cash flows and the valuation model used. Whether it is buying or selling, a solid understanding of pricing is essential to ensure that you are paying the right price. But, what is the purpose and importance of derivative valuation?

Purpose of derivative valuation

Derivatives valuation is the process of determining the value of the derivative contract. The transactions in the financial derivatives market are governed by specific contracts, which provide for trading and settlement. The function of derivative valuation is to find out a fair value that can be used for effective economic activities between two counterparties. At the same time, various strategies can be applied on the basis of the derivative valuation. As such, transparency and accuracy of the values are vital for smooth transactions.

When do you need to value derivatives?

Derivative valuation is a core process at the inception of a financial instrument. However, the strategy and success of derivative valuation depend upon the right inputs and assumptions that have been adhered to in performing the valuation. Following are some of the common reasons to value derivatives:

Issuance – At the time of issuing a derivative instrument, it is essential to value the derivative contract, which shows the fair value of the instrument. As such, derivative valuation acts as an important pricing mechanism for derivative instruments.
Purchase – On the basis of the derivative valuation, the price at which the derivative instrument is bought can be determined. When purchasing a derivative, it is necessary to determine the right price in order to get a view of the effectiveness of the pricing strategy.
Reporting and accounting – As a result of derivative valuation, properly accounting and reporting activities in the derivative contract can be carried out. This is because the accounting value involves determining the fair value of the derivative instrument.

How do you value financial derivatives?

Well, the methodology for determining the fair value of derivative contracts depends upon the specific nature of financial instruments. Here are some of the most commonly used valuation models in derivatives in accordance with the financial instruments:

Options – Typically, the strike price of an option is the key parameter for derivative valuation. As such, the strike price is derived from the current market value of the instrument and the underlying asset. The strike price refers to the price at which the option contract can be exercised.
Future – To determine a value of a derivative contract, the notional value is calculated by multiplying the contract size by the price per unit of the commodity that is represented by the spot price.
Swap – To value a derivative contract, it is essential to determine the interest rate or swap rate for the notional value. The swap rate is calculated as:

Rollover rate = (Base currency interest rate – Quote currency interest rate) / (365 x Exchange Rate)

Use credit valuation adjustment (CVA) to value derivatives

The CVA is a method of valuing derivatives in the financial markets. Basically, it is the price that a trader is willing to pay in order to hedge the counterparty credit risk of a derivative instrument. The CVA is the difference between the risk-free portfolio value and the true portfolio value.

CVA valuation methods

Now that you have an idea about CVA, it is essential to consider the valuation methods that can be applied to derivative instruments. There are multiple ways of valuing a derivative instrument. The following are some of the most common CVA valuation methods:

Swaption type valuation – The swaption approach is a popular way of valuing financial derivatives. In this process, the counterparty credit spread is used to estimate the replacement value of the asset. As such, this method is considered complex and requires a high level of expertise.
Simple approach – In this method, the mark to the market value of the instrument is calculated. Further, it is repeated, and discount rates by the counterparty’s credit spread are adjusted. Lastly, the difference between these two will result in the value.
Simulation modeling – In simulation modeling, the simulation of market risk factors and risk factor scenarios are used. Then, it requires revaluing the financial derivatives using multiple simulation scenarios. The exposure profile of each counterparty is established with the help of aggregating the resulting matrix. The exposure profile expected from each counterparty is adjusted to derive the collateralized expected exposure profile.

Get experts help to value your derivatives with Eqvista!

The derivative market is a diverse market that covers a wide range of instruments. For effective trading, a trader should gain a full understanding of the basics, valuation and trading strategies that are associated with derivative instruments. While the derivative valuation can be approached in multiple ways, the correct method of valuation is dependent upon the characteristics of the specific derivative instrument. Eqvista is the leading financial service provider, offering accurate and reliable approaches to derivative valuation. To learn more about our valuation services, contact us today and we will be happy to assist you!

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