Although product control is not responsible for pricing client trades or risk managing the trading portfolio, we need to understand how to source or construct a price for each type of financial instrument that we interact with. This understanding assists controllers in the execution of the many controls which product control undertakes. This chapter intends to guide you on how to approach pricing which will be illustrated through examples for several financial instruments.
How to Approach the Pricing of a Financial Instrument
When faced with a financial instrument that we are unfamiliar with, there are a series of steps that we can progress through to understand how to source or construct a price. Although quite basic, these steps provide a solid approach to understanding the pricing of the financial instrument. Figure 6.1 outlines these steps.
Figure 6.1 Approach to pricing a financial instrument
Before jumping straight into where and how you source a price for a financial instrument, it is important to first consider the nature of the financial instrument. The simple question of “what is it” brings to the fore three questions regarding the nature of the instrument:
Cash flows. There are two aspects to consider regarding cash flows:
The first is to consider what cash flows occur during the life of the instrument. Some of the most ...
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