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Reading 57  Basics of Derivative Pricing and Valuation (Intro)
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It is important to understand how prices of derivatives are determined. Whether one is on the buy side or the sell side, a solid understanding of pricing financial products is critical to effective investment decision making. After all, one can hardly determine what to offer or bid for a financial product, or any product for that matter, if one has no idea how its characteristics combine to create value.

Understanding the pricing of financial assets is important. Discounted cash flow methods and models, such as the capital asset pricing model and its variations, are useful for determining the prices of financial assets. The unique characteristics of derivatives, however, pose some complexities not associated with assets, such as equities and fixed-income instruments. Somewhat surprisingly, however, derivatives also have some simplifying characteristics. For example, as we will see in this reading, in well-functioning derivatives markets the need to determine risk premiums is obviated by the ability to construct a risk-free hedge. Correspondingly, the need to determine an investor’s risk aversion is irrelevant for derivative pricing, although it is certainly relevant for pricing the underlying.

The purpose of this reading is to establish the foundations of derivative pricing on a basic conceptual level. The following topics are covered:

  • How does the pricing of the underlying asset affect the pricing of derivatives?

  • How are derivatives priced using the principle of arbitrage?

  • How are the prices and values of forward contracts determined?

  • How are futures contracts priced differently from forward contracts?

  • How are the prices and values of swaps determined?

  • How are the prices and values of European options determined?

  • How does American option pricing differ from European option pricing?

This reading is organized as follows. Section 2 explores two related topics, the pricing of the underlying assets on which derivatives are created and the principle of arbitrage. Section 3 describes the pricing and valuation of forwards, futures, and swaps. Section 4 introduces the pricing and valuation of options. Section 5 provides a summary.

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