How To Price A Derivative

David Gershon, CEO of SuperDerivatives, speaks about how complex derivatives can be accurately priced, and how important it is in today's economic climate for custodian banks
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David Gershon, CEO of SuperDerivatives, speaks to about how complex derivatives can be accurately priced, and how important it is in today’s economic climate for custodian banks to have an independent view of their portfolios

During this period of volatility and beyond, confidence, accuracy and transparency are among the most critical things required for stable markets. Custodian banks and other institutions across the buy- and sell-side have become acutely aware of the risks posed by mispricing complex derivatives as the rules and landscape of the financial markets have shifted.

It is important that the market as a whole now seeks to rebuild confidence and trust through more transparent valuations and asset pricing. At its core is the urgent need for institutions to accurately value and manage their derivatives portfolios. We champion transparency and accuracy in pricing this is what the market needs.

By their very nature, derivatives are financial instruments whose value depends on another underlying asset and which allows buying and selling of the same asset on two markets, the spot market and the secondary derivatives market.

Their chief use is to mitigate the risk of economic loss from changes in the value of the underlying asset an activity known as hedging. Alternatively, derivatives can be used by investors to speculate and increase the profit arising if the value of the underlying moves in the direction they expect.

Derivatives can be based on a range of underlying assets including currencies, equities, commodities, power and energy, interest rates and credit. They are broadly split into simple or vanilla options, and more complex or exotic derivatives such as options on a basket of assets, knock out, or digital option. In different assets there are special structured products that are popular in the industry, such as faders in FX, cliquet in equity, snowball in interest rates and cracks in energy.

These derivatives are measured and priced as assets or liabilities at fair value, but their complexity requires a special accurate model, accurate market data from an independent source and of course a reliable pricing system to accurately price derivatives.

Pricing derivatives depends on multiple factors including data quality, models and implementation and skill in using the models, as well as operational and IT support. Each of these ingredients is instrumental in producing a defendable verifiable price level.

The price that matters for trading operation is the execution price, i.e. the price of an actual transaction taking place or tradable bid and offer quotes by market makers who are willing to execute on these prices at significant trade volume. These depend on factors such as the size of an order, counterparty risk, competitive situation and relationship between counterparties. Ideally the bid and ask prices include several leading market makers.

The accounting price is the price of a security held on the books of a trading entity, rather than the original transactional price, and should reflect the fair market price of the security.

This is a much less certain number that depend on additional factors including liquidity levels, similarity to traded securities, available market data, pricing models, documentation and legal considerations.

The current standard fair market price is often called the mark-to-market price, which is the price that an asset would fetch on the market if sold immediately. Another way to describe it is the median between the bid and offer prices of the asset in the market place. Recently, however, mark-to-holding has been promoted as a serious alternative for illiquid assets.

In the mark-to-holding approach, the price of an asset is derived from an assumption that the asset will be held on the books until maturity. It is argued that this accounting method will avoid penalising financial institutions and corporations, which are engaged in long-term investment in complex assets.

Mark-to-holding value of even a good asset in difficult market conditions is not unlike trying to drive a car on the road full of potholes. Even if the car happens to be in a good condition, the environment renders the value of the car much smaller than its condition implies.

Mark-to-market is the current preferred method of valuation, truly reflecting the market conditions and potential benefits of holding a security. If valuations are done prudently and expertly, it reduces the valuation uncertainty.

Pricing of any financial instrument, derivative or not, depends on many factors. Quality data is the first critical ingredient in assessing the fair value of any security. In derivatives using the right model is almost equally critical. Whether using great data and mediocre model or mediocre model with great data- in both cases the calculated asset value will not be close enough to its true market value.

Instrument coverage is almost just as important, as it is desirable to work with a single trusted valuation provider for all instruments. This ensures consistency in the valuation of related assets and at the same time helps to reduce operational risk and overheads and to keep this option cost effective.

Quality and reliability of the data is the key to good pricing. Together with well tested and models gauged to actual market quotes, this ensures that pricing is done with the best available market information.