Derivative Securities

Valuing Derivative Securities

Many derivatives fall into the general categories of forwards, futures, swaps, calls and puts. The market for derivatives is a "zero-sum game" in the sense that total profits and losses across counterparties are zero.

Derivative securities include:

• swaps
• forwards and futures
• exchange-traded calls and puts
• explicit corporate options
• corporate debt securities
• government securities
• mortgages and insurance
• securities of other financial institutions
• exotic options
• other financial options
• natural resources
• capital assets
• other non-financial options

These securities confer a right to buy or sell an underlying asset, typically a financial security like a stock or bond, at a fixed price within a designated period of time. Derivative securities are typically valued using a version of the Black-Scholes Option Pricing Model. Other valuation methods include various versions of the Binomial Model.

The two key inputs in valuing derivative securities are:

1. The price of the underlying asset, and
2. The volatility of the asset's return.

For example, if a stock option is being valued; the price of the underlying asset is the stock price. If a public firm issued the stock, then the price of the underlying asset, that is, the stock price, can be easily determined from the public exchange where the stock is traded.

The volatility of the asset's return is generally measured as the standard deviation of the stock's return. The inputs needed to implement this model are often difficult to calculate and, therefore, the calculation requires careful and diligent analysis to ensure consistency between the value of the derivative in question and the value of its underlying asset.

ValueScope analysts are experts in all facets of derivative securities and can create sophisticated models to simplify the understanding and value of often complex financial instruments.