Derivatives valuations are determined by formulas that require various inputs. Futures contract prices are valued by adding spot price plus cost of carry. Options contracts are priced using complex financial calculus formulas. Intrinsic and extrinsic values are used to determine the fair market price of an option. On the basic retail level, futures and options are the most commonly traded derivatives.
Derivatives are financial contracts priced according to the value of an underlying asset plus other considerations. The underlying assets for futures contracts are commodities. Commodities such as gold, oil and grain have a spot price — the price at which an asset can be bought or sold for immediate delivery. A contract for delivery at some future date is a futures contract.
To determine the fair market price for futures derivatives valuations, the spot price is discovered through a process of supply and demand. The delivery of the asset will not take place until some future date, so a "cost of carry" must be added. Cost of carry might include storage fees and insurance fees in the case of perishable commodities. Interest rates would be a factor in financial futures, and dividends might play a roll in pricing index futures.
Derivatives valuations for futures contracts are generally greater than spot price values. This normal situation is termed "contango." In some cases, typically with currency futures, the futures price might be less than the spot price, which is called backwardation. In either case, the futures price and the spot price will be equal at contract expiration, and delivery will occur. Derivatives valuations are fairly priced by market participants.
In the options market, derivatives valuations are conducted through the use of option pricing models. The most widely used pricing models are the Black-Scholes model and the binomial model. Both models are based on similar theoretical assumptions and foundations. The key elements used in option pricing are spot price, strike price, volatility, interest rates and time until expiration.
A change in any one of these elements will result in a change in the value of the option. An option purchased today will have less value tomorrow because of time decay. Conversely, an option sold today will be of greater value tomorrow because of captured time value. Of course, these statements are true only if all other elements remain unchanged. The key to understanding derivatives valuations in the options market are what are called the Greeks.
The option Greeks are values representing the key elements of option pricing. The Greeks define the scope of change in value for a change in one of these elements. Delta is related to a change in the underlying asset's value, and gamma is related to a change in delta. Theta is a value related to time left until expiration, and vega is the relationship between value and volatility. Rho is related to the interest rate.
Intrinsic value is the the money value of the spot price in relation to the strike price. This can be a positive or negative value. When positive, it is referred to as "in the money." When negative, it is referred to as "out of the money." Extrinsic value is basically the value of the Greeks.
All of these factors are used in option pricing. The pricing models in use are good but fall short as an exact science. Derivatives valuations are sometimes overpriced and sometimes underpriced. Traders can capitalize on these situations and do so quite frequently.