What Are the Different Methods of Determining Derivatives Valuations?

Financial derivative product price risk, as an innovative trading method that uses contracts to lock future delivery prices, also faces the risk of incorrect price predictions. Since derivative products are targeted at native financial products, the price risk of financial derivative products is essentially a part of interest rate risk, exchange rate risk, and security price risk. However, as the transaction value of financial derivatives is generally large, small changes in their prices may cause significant losses and serious consequences. Therefore, the price risk of financial derivatives has aroused widespread concern in the financial community.

Financial Derivatives Price Risk

Financial derivative product price risk refers to the possibility of loss in the transaction of financial derivative products due to the uncertainty of the price of the transaction object. Since the creation of financial derivatives in the 1970s, development has been exceptionally rapid. Its basic forms include forward agreements, financial futures, financial options and financial swaps.

The basic forms of financial derivatives include financial futures, options, financial swaps and forwards. The corresponding financial derivative product price risks are financial futures price risk, financial Option price risk, financial swap price risk and forward agreement price risk. ^[1]

Financial futures price risk refers to the possibility that an actor will suffer losses due to uncertain changes in the price of financial futures within the agreed time. If investors expect a certain type of financial futures price to rise, they tend to buy that type of futures in order to make a profit through delivery after the market price rises. However, if futures prices not only rise, but fall, they will have to close their positions at a lower market price or buy cash at a higher futures execution price, thereby incurring losses. The more the market price falls, the more losses they suffer. Conversely, if investors expect a certain type of financial futures price to fall, they often sell that type of futures in order to make a profit through delivery after the market price has fallen; however, if the futures price not only does not fall but rises, investors will have to You close your position at a higher market price or sell your existing stock at a lower futures execution price, thereby incurring losses. The more the market price rises, the more losses they suffer.

Financial option price risk refers to the possibility of causing losses to investors due to the uncertainty of the price changes of basic products. However, the financial option price risk has different risk characteristics for the buyer and seller of the option. If the change in the price of the underlying product is not consistent with the expected direction of the option purchaser within the agreed time, the option purchaser can waive his right. In this way, the maximum loss he has suffered is the option fee paid; The buyer's expected direction is the same, but the favorable change in the price of the basic product is still not enough to cover the option fee, and the option purchaser can exercise the right to recover part of the loss; on the contrary, if the change in the price of the basic product is consistent with the expected direction of the option buyer, the option seller Will be in a very disadvantaged position, because for the option seller, the option contract only stipulates the obligations that he must perform, but does not give him any rights that can be exercised. Therefore, the greater the change in the price of the underlying security, the greater the potential loss for the option seller.

Financial swap price risk refers to the possibility that an actor may suffer losses due to uncertain changes in the exchanged interest rate or currency exchange rate within the agreed period. In interest rate swaps, it is usually the exchange of fixed interest rate payment methods and floating interest rate payment methods. For a trader who pays a fixed interest rate after the swap, his expenditure is stable. Although there is a risk of relative losses due to the decline in market interest rates, this risk is relatively small. However, for a trader holding a floating interest rate after the swap, his expenditure will change accordingly as the market interest rate changes. If the market interest rate is higher than the fixed interest rate at the time of the swap, he will suffer losses. The higher the market interest rate, the greater the loss. In currency swaps, both parties to the swap may suffer losses due to uncertain changes in exchange rates and interest rates. The greater the changes in exchange rates and interest rates, the greater the possible losses.

Forward contracts include forward foreign exchange contracts and forward interest rate contracts. In forward foreign exchange transactions, if the spot exchange rate at the expiry date is higher than the contract exchange rate, the seller of the forward exchange contract will suffer losses; if the spot exchange rate at the expiry date is lower than the contract exchange rate, the The buyer will suffer losses. The greater the difference between the two exchange rates, the greater the loss suffered by one of them. The possibility of such losses due to uncertain changes in the spot exchange rate is the price risk of forward foreign exchange contracts. Similarly, the so-called price risk of a forward interest rate contract refers to the possibility that one party in the contract will suffer a loss due to an uncertain change in future actual interest rates relative to the contract interest rate.

This shows that financial derivative product price risk is part of exchange rate risk, interest rate risk, and security price risk. However, since the transaction value of financial derivatives is generally large (ie, the risk exposure is very large), even small changes in their prices may cause significant losses and serious consequences. Therefore, the price risk of financial derivatives has aroused widespread concern in the financial community.