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 a target price on a financial instrument, in lieu of or in the absence of its current market price. The calculation of the fair value of derivatives implies the consideration of factors that affect the probability that the derivative will be beneficial for 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 trade in the future, although one party may have the option to decide whether the deal goes ahead. In each case, the terms of trade are based on the price or exchange rate of a separate asset that can, and generally will, change between the close of the derivative transaction and the agreed-upon date of exchange. One or both parties to the derivatives business may sell the rights to complete the deal, which is 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 actually “worth” to hold a position in the derivative, which may differ from the price at which it is sold. Most fair value measurement methods use an objective formula, although deciding which factors to include in the formula is subjective.
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 the derivative exchange expires, and the current risk rate of return available. – free investments, such as government bonds. Most attempts to assess the fair value of derivatives use factors similar to this.
There are two main reasons for calculating 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 being financially advantageous. A second reason is to produce value for the use of the derivative by including it as an asset on the balance sheet. There are complicated rules for how companies must make this calculation, depending on the accounting standards to which the company is subject and the precise type of derivative in question.