Encyclopedia of Financial Models I

Pricing of Futures/Forwards and Options

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

Abstract: There are various models that been proposed to value financial assets in the cash market. Models for valuing derivatives such as futures, forwards, options, swaps, caps, and floors are valued using arbitrage principles. Basically, the price of a derivative is one that does not allow market participants to generate riskless profits without committing any funds. In developing a pricing model for derivatives, the model builder begins with a strategy (or trade) to exploit the difference between the cash price of the underlying asset for a derivative. The market price for the derivative is the cost of the package to replicate the payoff of the derivative.

Derivative instruments play an important role in financial markets as well as commodity markets by allowing market participants to control their exposure to different types of risk. When using derivatives, a market participant should understand the basic principles of how they are valued. While there are many models that have been proposed for valuing financial instruments that trade in the cash (spot) market, the valuation of all derivative models is based on arbitrage arguments. Basically, this involves developing a strategy or a trade wherein a package consisting of a position in the underlying (that is, the underlying asset or instrument for the derivative contract) and borrowing or lending so as to ...