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The process of pricing derivatives is best understood by examining certain fundamental principles.
Aside from understanding the difference between forward commitments and contingent claims, what purposes derivatives serve in today’s markets, as well as what people think of them, it is very important to understand what market forces impact how derivatives are priced. ArbitrageThe most important concept in derivative pricing is arbitrage. Arbitrage becomes possible when two identical or very similar assets trade at two different prices. If and when such a situation occurs, a trader may have an opportunity to realize virtually riskless profit because there would be no need to commit any actual money to the trade. For example, if a trader identifies a stock that trades at $85.00 a share in one market and at $90.00 a share in the other, he could buy shares in the cheaper market and sell the same shares in the more expensive market. If both sides of the trade are executed successfully, the trader makes a profit of $5.00 without risking any money of his own. Of course, such a situation is likely to be fluid and prone to quick changes. Otherwise, many market participants would be able to do this and eventually drive the stock’s price down in the more expensive market, and up in the cheaper market. Law of One PriceThe principle which claims that no arbitrage opportunities should exist in an efficient market is generally referred to as the law of one price. Derivatives trade in many markets around the globe, so it is entirely possible to have more than one spot price for identical or similar derivatives. Of course, such a possibility would seem to be in violation of the law of one price. However, in reality, the law’s fundamental value is still upheld, sometimes through arbitrage and sometimes through its own devices. For example, two assets trading in different markets and at different prices may only be similar, but not equivalent enough to actually violate the law of one price. In addition, even if the two assets trading in different markets and at different prices were identical, there might be additional costs accompanying such an asset that could offset profits from any such price difference. Furthermore, if and when the law of one price is truly violated, it is also eventually reestablished through arbitrage. Namely, it is an arbitrageur’s job to seek profit in price discrepancies until an asset’s price equilibrium is reached and the opportunity for profit is eliminated; unless, of course, the arbitrageur wishes to commit his or her own funds to the trade. No Arbitrage Equals Efficient MarketsIf markets are considered relatively efficient, no arbitrage opportunities can exist. The fundamental principle of efficient markets states that potential for abnormal returns does not really exist, aside from random occurrences. Since arbitrage profits typically fall under the category of abnormal returns, the efficient market hypothesis claims that those should be easy to identify, easy to reproduce by hoards of investors, and thus eliminated in the process.
The copyright of the article Derivatives Pricing Principles in Derivatives Investing is owned by Inya Ivkovic. Permission to republish Derivatives Pricing Principles in print or online must be granted by the author in writing.
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