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What is Involved in a Derivatives Analysis?

John Lister
John Lister

The most common form of derivatives analysis involves using a range of criteria to attempt to determine a fair price for a derivative and thus whether a particular offer makes rational sense to take up. A variation on this process involves analyzing a derivative's potential to fulfill a role beyond simply making money, such as in hedging. In a wider context, derivatives analysis is an economic and political procedure looking at how such investments affect an economy and society.

Derivatives are any financial product that derives its value from an entirely separate asset. An example is a futures contract where two traders agree to a stock sale at a future date for an agreed price, regardless of what the prevailing market price is on that date. One party may sell its interest in the deal to another investor in the meantime, thus turning the futures contract into an asset in its own right.

Businessman with a briefcase
Businessman with a briefcase

Generally, the price of a tradable derivative is determined by the market. Derivatives analysis attempts to compare the current market price to what is considered a fair price for the derivative given its inherent risk and potential reward. If the analysis shows it is, on paper at least, worth more than its current market price, it is considered a comparatively good value investment.

Most such analysis involves a computerized model. This can take account of many different factors such as the value of the asset the derivative is based on and the time remaining until the derivative comes due, such as the completion date of a futures contract. One factor that is usually included in such models and might otherwise be overlooked is the current return on risk-free or low-risk investments such as government bonds. This is because a derivative that is normally a good bet becomes much less attractive in relative terms when risk-free investments are offering high returns.

Not all derivatives traders see making money from the derivative as the primary aim. Some will be hedging against other price movements: for example, setting up a derivative that will pay off in circumstances that mean other investments they've made go against them, thus mitigating potential losses. In currency exchange derivatives, the goal might be to bring certainty to the domestic currency value of a scheduled future payment in a foreign currency. Such situations can be covered by a derivatives analysis, though it will necessarily be more complicated.

Derivatives analysis is also a term for wider studies of the activity itself. Economists may analyze how the presence of, and level of activity in, the derivatives market has affected financial dealings as a whole. Political analysts may analyze whether the activity has consequences for society as a whole.

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