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A derivative is a financial instrument that derives its value from another asset. Fair value is an attempt to put an objective price on a financial instrument, either instead of or in the absence of its current market price. Calculating the fair value of derivatives involves taking into account factors that affect how likely the derivative is to prove beneficial to the holder. A company listing the fair value of derivatives on its balance sheet must follow certain principles such as tracking the value of the underlying asset.
There are a wide variety of derivatives available. Generally they involve an agreement to carry out an exchange in the future, though one party may have the option to decide if the deal goes ahead. In each case, the terms of the exchange are based on the price or exchange rate of a separate asset that may, and usually will, change between the derivative deal being struck and the date of the agreed exchange. One or both parties in the derivative deal can sell on the rights to complete the deal, 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 the same as its current market price. Instead it is an attempt to give an objective measure of what holding the position in the derivative is actually "worth," which may differ from the price it is selling at. Most methods of measuring fair value use an objective formula, though deciding what factors to include in the formula is itself subjective.
One of the most common examples of a formula to measure 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 this price has fluctuated in the past, the terms of the derivative, the time left until the derivative's exchange comes due, and the current rate of return available from risk-free investments such as government bonds. Most attempts to assess fair value of derivatives use similar factors to this.
There are two main reasons to calculate 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 it is a good value investment that is more likely than not to wind up financially worthwhile. A second reason is to produce a value for the derivative to use when listing it as an asset on a balance sheet. There are complicated rules about the way companies must make this calculation, depending on both which accounting regulations the company comes under, and the precise type of derivative concerned.
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