Factors Affecting Derivative Pricing

In the previous chapter, we have discussed pricing derivatives formulas and technicals. Today, we are going to learn the factors that affect the pricing of the derivatives, which will give a view into how these financial instruments work.

Understanding Derivatives

A derivative is a financial contract whose value is derived from the value of one or more underlying assets. These may include different types of stocks, commodities, and bonds. Derivatives are available in many forms; the most popular ones are futures and options, and their pricing depends on several market and economic factors.

Key Factors that Affect the Pricing of Derivatives

Spot Price: It reflects the price in the current market. As in equity derivatives, for example, stock futures contract prices generally move along with the movement of the spot price of the stock. Therefore, if the spot price of the stock increases, its price, as well as its derivatives' prices, tends to increase and vice versa. In derivatives, the spot price gives the base price to that particular derivative.

Time to expiration: Time remaining for the expiration of the derivative significantly influences its price. The longer the duration to expiration, the greater the likelihood that the underlying price's fluctuation leads to the derivative being valued more, particularly options. Since there is more uncertainty over this long period, accordingly the time value of the option will also increase.

On the other hand, when expiration time approaches, then the derivative also starts reflecting the current market price of the underlying asset, because there is less time to move. For example, options on the Nifty index expire on Thursdays, mostly following a predictable expiry cycle, and that reflects in their pricing dynamics.

Volatility: It is the magnitude of change in the price of the underlying asset over a period of time. The higher the volatility, the higher the chances of extreme movement in prices, which would raise the value of the derivatives. This factor is most crucial for options because higher volatility increases the probability of an option ending up in-the-money. Events such as elections, budget announcements, or economic changes heighten implied volatility and, thus, the premium on options.

Interest Rates: Interest rates also affect derivatives such as futures contracts. When the interest rate increases, so does the carrying cost; thus, the price of the underlying asset goes up in futures. For instance, a rise in the interest rate by the RBI could imply higher financing costs of futures contracts and, hence, affect their prices.

Dividends and Carrying Costs: For equity derivatives, expected dividends may definitely affect pricing. In all cases, futures contracts are usually cheap compared to the underlying to the extent that the buying of futures does not assume the dividend entitled to and, therefore, must be lower. Of course, for commodity derivatives, carrying costs involved in storing and insuring play an important cost factor in determining the overall price of the derivative.

Conclusion

Pricing any derivative depends on a cocktail of variables: the spot price, time to expiration, volatility, interest rates, and dividends or carrying costs. The ability to comprehend such dynamics places the trader or investor in a better position to handle the complexity of the derivative markets and handle risks and opportunities with confidence. In the next chapter we will discuss Hedging Strategies with Derivatives in details.