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What are the Different Methods of Derivatives Pricing?

Dana DeCecco
Dana DeCecco

Several derivatives pricing models and methods are used to determine the fair market value of a derivatives contract. The Black-Scholes pricing model is often used in options pricing. The binomial options pricing model is considered more accurate and is used by professional options traders. Other methods have been developed using stochastic calculus and complicated mathematical formulas. Commodity trading depends on accurate futures pricing and is basically determined by future supply and demand.

The Black-Scholes model was developed in 1973 by economists Fischer Black, Myron Scholes and Robert Merton. The formula is widely used to determine the fair market value of options. The basic method assigns variables for which a formula is applied. The variables used are current asset price, strike price, time to expiration, volatility and risk-free interest rate. Calculators are available to input the variables and figure the fair market value of the derivatives contract.

Businessman with a briefcase
Businessman with a briefcase

There are many variations of the Black-Scholes model that require additional factors. The binomial options pricing method, which models the dynamics of the options' theoretical value, is more accurate. It is used to calculate the fair market value of American and European-style options. Options pricing elements are commonly referred to as the Greeks because they are represented by Greek letters, such as delta, vega, theta and rho. The complicated process of derivatives pricing falls under the category of financial engineering.

Futures contracts are exchange-traded derivatives with standardized contracts. The underlying assets can be commodities, indexes, bonds and currencies, and they are widely varied. Derivatives pricing on these contracts is somewhat easier to understand than options derivatives pricing. The basic method of pricing futures contracts is simply the current spot price plus the cost of carry, with the result being equal to the futures price. The current spot price is readily available.

A futures contract relates to delivery at a future date, so the cost of holding and handling the asset is referred to as its cost of carry. The cost of carry will vary according to the asset being traded. Commodities such as agricultural products incur carry expenses such as storage, insurance and possible labor costs. Currency futures require the calculation of the difference in interest rates on currency pairs. The cost of carry is different for different assets.

Trading derivatives does not require the investor to have an in-depth knowledge of derivatives pricing. Stochastic calculus is not a prerequisite to options trading. The options trader should understand the Greeks and how they affect the value of an option. The futures trader should understand basis, spreads and cost of carry in futures pricing. Online resources are available to educate the derivatives investor.

Most derivatives brokers offer a variety of courses and classes to aid the investor in understanding and trading derivatives. Online advisories and software programs are available to help determine the fair market value of derivatives. Derivatives pricing is a complex field that is modestly accurate at best, because the human element of derivatives trading is difficult to factor into the equation.

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