What Are Derivative Pricing Models?

Derivative pricing models are techniques used by investors to try to find an objective measure of a derivative's true value. This is then compared to its actual market price to see whether it represents a worthy investment. Each model takes into account different known factors that affect the derivative. While derivative pricing models operate in an objective manner, the selection of the factors covered by the model is itself subjective.

A derivative is a financial agreement based on an underlying asset. In most cases, this agreement is based on a transaction to take place on a future date involving the asset, but with a price fixed in advance. The difference between the agreed price for the transaction and the actual market price of the underlying asset at the time of the transaction usually determines which party in the deal makes a profit. Examples of derivatives include futures agreements, options agreements and swaps. Once a derivative agreement is made, the parties involved can sell their interest in it, which known as trading the contract.

Somebody considering buying a derivative will need to determine an acceptable price to pay, taking into account the risk the deal presents and the potential rewards. One way to do this is to use derivative pricing models. These attempts to work out what a "fair" price would be for the derivative at the present moment. This can then be compared to the current market price for the derivative, which is determined by demand and supply.

One of the best known derivative pricing models is the Black-Scholes Option Pricing Model. This takes into account six factors. These factors are: how long the derivative has left to run before the transaction date, the current price of the underlying asset, the fixed transaction price under the derivative, what dividends the investor is missing out on by buying a derivative rather than the underlying asset itself, the interest saved by not having to pay for the underlying asset immediately, and the volatility of the underlying asset.

While the concept of the model is relatively simple, the mathematics used to make the calculation is relatively detailed, and producing a chart showing the range of potential "fair" prices involves a three-dimensional graph. Fortunately, computer programs make it much easier to calculate values using derivative pricing models. Such programs also allow variations on models, whether than means switching to a completely new model, or tweaking an existing model to give greater emphasis to an individual factor.