How are derivatives priced?

Derivatives are priced by creating a risk-free combination of the underlying and a derivative, leading to a unique derivative price that eliminates any possibility of arbitrage.

How is the price of a futures contract determined?

A futures price is determined by the cost of its underlying asset and moves in sync with it. The cost of futures will rise if the cost of its underlying increases and will fall as it falls. But it is not always equal to the value of its underlying asset. This price difference is termed Spot-Future parity.

Is OTC quote driven?

OTC markets are known as quote-driven markets. Each market marker provides bid and offer quotes on a range of instruments and all trades are executed via these market markers.

Can retail investors trade OTC derivatives?

Forwards: A forwards contract is like a futures contract. But forwards are not standardized or regulated and are only traded in the over-the-counter (OTC) markets, usually between institutional investors or large organizations. Forwards don’t trade on futures exchanges by retail investors.

How is price of derivative related to the price of underlying asset?

Law of one price: If two assets have the same expected return in the future, then their market price today must be the same. The price of a derivative is tied to the price of the underlying. For example, if the price of a stock goes up, then a call option on the stock also goes up.

What is the forward price for derivatives?

Forward price is the price at which a seller delivers an underlying asset, financial derivative, or currency to the buyer of a forward contract at a predetermined date. It is roughly equal to the spot price plus associated carrying costs such as storage costs, interest rates, etc.

Why future price is higher than spot price?

Futures prices above the spot price can be a signal of higher prices in the future, particularly when inflation is high. Speculators may buy more of the commodity experiencing contango in an attempt to profit from higher expected prices in the future.

What is the uniform pricing rule?

Call markets commonly use the uniform pricing rule. Under this rule, all trades execute at the same price. The market chooses the price that maximizes the total quantity traded. Continuous trading markets use the discriminatory pricing rule.

What is uniform pricing rule?

How are prices quoted in a dealer market?

A dealer market is a place where dealers engage in buying and selling of a specific financial instrument electronically using their own account, without involving a third party and make the market by quoting the offer price (price at which they are ready to sell) and bid price (price at which they are ready to buy).

Are FX forwards OTC derivatives?

Currency forwards are OTC contracts traded in forex markets that lock in an exchange rate for a currency pair. They are generally used for hedging, and can have customized terms, such as a particular notional amount or delivery period.

Who is allowed to trade derivatives?

There are four kinds of participants in a derivatives market: hedgers, speculators, arbitrageurs, and margin traders. There are four major types of derivative contracts: options, futures, forwards, and swaps.

Derivatives are priced by creating a risk-free combination of the underlying and a derivative, leading to a unique derivative price that eliminates any possibility of arbitrage.

What is derivative pricing through arbitrage?

Derivative pricing through arbitrage precludes any need for determining risk premiums or the risk aversion of the party trading the option and is referred to as risk-neutral pricing. The value of a forward contract at expiration is the value of the asset minus the forward price.

How is the fair value of a derivative calculated?

Depending on the type of derivative, its fair value or price will be calculated in a different manner. Futures contracts are based on the spot price along with a basis amount, while options are priced based on time to expiration, volatility, and strike price.

Are FX derivatives subject to the Treasury determination?

These rules clearly distinguished FX derivatives that could be subject to the Treasury Determination from FX derivatives that would not be subject to the Treasury Determination.