What is Derivatives Modeling?

Jim B.
Jim B.
Businessman with a briefcase
Businessman with a briefcase

Derivatives modeling refers to the technical analysis performed by investors trying to come up with a fair price for derivatives traded in the open market. Unlike stocks or other equities that have a price based on market supply and demand, derivatives are speculative investments based on many factors attached to the underlying assets. For that reason, pricing models are used by investors to attempt to attach a fair price to a common derivatives contract. Many of the techniques used in derivatives modeling are extremely complicated but can be useful to experienced investors.

While many people who invest money do so by simply buying shares of stock in companies, others get involved with more complex investment instruments known as derivatives. Derivatives are contracts that give the owner the right to buy shares of some underlying asset at some point in the future. The investor who owns a derivatives contract doesn't actually own the physical asset underlying the contract, which is why he might use derivatives modeling to place a value on that contract.

Many different factors come into play when discussing the various models used for derivatives modeling. The most common derivatives are options and futures, which give the contract holder the right to buy the asset at some point in the future. These contracts are rarely actually exercised, but they can be bought and sold by investors. This fact makes determining how much the contracts are worth crucial to investors.

Most derivative contracts have similar elements in them that are plugged into derivatives modeling methods to produce a value on an option or futures contract. The market price of the underlying asset is one factor, as is the volatility of that asset as the contract goes forward. Each contract has an expiration date that also factors into pricing models, as do any carrying charges like dividends or interest rates attached to the underlying security. Finally, the strike price, which is the price at which the holder of the contract may exercise her option, is another huge component of pricing models.

Although systems for derivatives modeling vary in complexity and technique, many are concerned with determining the Delta value in a derivatives contract. The Delta value is a measurement of the percentage change in the value of an options contract when the price of the underlying asset changes by a point in either direction. By determining this Delta value, an investor could theoretically know how much a derivative contract would be worth at some point in the future based on the expected movement in the underlying security.

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    • Businessman with a briefcase
      Businessman with a briefcase