How do I determine the fair value of derivatives?

The fair value of derivatives is not necessarily equal to their current market price.

A derivative is a financial instrument whose value is derived from another asset. Fair value is an attempt to place an objective price on a financial instrument, instead of or in the absence of its current market price. The calculation of the fair value of derivatives involves consideration of factors that affect the likelihood that the derivative will be beneficial to the holder. A company that lists the fair value of derivatives on its balance sheet must follow certain principles, such as tracking the value of the underlying asset.

There is a wide variety of derivatives available. They usually involve an agreement to make an exchange in the future, although one party may have the option to decide whether the deal goes ahead. In each case, the terms of exchange are based on the price or exchange rate of a separate asset that can, and generally will, change between the derivative deal being closed and the agreed exchange date. One or both parties in the derivatives business can sell the rights to complete the deal, known as selling a position. In other words, the derivative is an asset in itself, complete with a market price.

The fair value of derivatives is not necessarily equal to their current market price. Rather, it is an attempt to provide an objective measure of what it is really “worth” to hold the position in the derivative, which may differ from the price at which it is selling. Most fair value measurement methods use an objective formula, although deciding which factors to include in the formula is subjective.

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One of the most common examples of a formula for measuring the fair value of derivatives is the Black-Schole formula. This formula takes into account the current price of the underlying asset, the degree to which that price has fluctuated in the past, the terms of the derivative, the time remaining until expiry of the derivative exchange, and the current available rate of return on risk – free investments, as government bonds. Most attempts to assess the fair value of derivatives use factors similar to this.

There are two main reasons to calculate the fair value of derivatives. The first is to compare this to the current market price. If the current market price is lower, the investor may conclude that it is a good value investment that is more likely to end up financially advantageous. A second reason is to produce a value for the derivative to use by listing it as an asset on the balance sheet. There are complicated rules about how companies should make this calculation, depending on which accounting regulations the company is subject to and the precise type of derivative in question.

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