A popular two-step procedure for valuing a European-style derivative is:
Calculate the expected payoff by assuming that the expected value of each underlying variable equals its forward value
Discount the expected payoff at the risk-free rate applicable for the time period between the valuation date and the payoff date.
We first used this procedure when valuing FRAs and swaps. Chapter 4 shows that an FRA can be valued by calculating the payoff on the assumption that the forward interest rate will be realized and then discounting the payoff at the risk-free rate. Similarly, Chapter 7 extends this, showing that swaps can be valued by calculating cash flows on the assumption that forward ...