The concept of fair value is essential in the world of finance, especially when it comes to derivatives. Derivatives are financial instruments that derive their value from an underlying asset or benchmark, such as a stock or commodity index. The fair value of a derivative is the estimated value of the contract if it were to be settled at a particular point in time. Understanding the concept of fair value is crucial for investors and traders as it enables them to make informed decisions when it comes to buying or selling derivatives.
The fair value of a derivative is determined by considering various factors, such as the underlying asset's price, the time remaining until the contract's expiration, and the contract's volatility. The fair value of a derivative is typically calculated using a mathematical model, such as the Black-Scholes model, which takes into account these factors to estimate the value of the derivative.
The Black-Scholes model is a mathematical formula used to calculate the fair value of European options. The model takes into account the underlying asset's current price, the option's strike price, the time remaining until expiration, the volatility of the underlying asset, and the prevailing interest rates. The model's output is the estimated fair value of the option, which can be used to price the option in the market.
The fair value of a derivative is not always equal to the market price of the contract. The market price of a derivative is determined by supply and demand in the market, and it can be affected by various factors such as changes in the underlying asset's price, changes in interest rates, and changes in market sentiment. The market price of a derivative can also be influenced by other factors such as liquidity, counterparty risk, and trading volume.
If the fair value of a derivative is higher than the market price, the derivative is said to be undervalued. In this case, an investor or trader may buy the contract with the aim of selling it at a higher price when the market price adjusts to the fair value. Conversely, if the fair value of a derivative is lower than the market price, the derivative is said to be overvalued. In this case, an investor or trader may sell the contract with the aim of buying it back at a lower price when the market price adjusts to the fair value.
The fair value of a derivative is also important when it comes to financial reporting. Companies that use derivatives in their business operations are required to report the fair value of these contracts in their financial statements. The fair value of a derivative is typically determined using a valuation model approved by accounting standards, such as the International Financial Reporting Standards (IFRS) or the Generally Accepted Accounting Principles (GAAP). Companies must disclose the valuation model used and provide information on the assumptions made in calculating the fair value of the derivatives.
The fair value of a derivative can also be affected by external factors such as regulatory changes, geopolitical events, and macroeconomic trends. For example, changes in interest rates or economic indicators can affect the fair value of interest rate derivatives, such as swaps and options, which are used to manage interest rate risk. Similarly, changes in commodity prices or supply and demand can affect the fair value of commodity derivatives, such as futures and options.
When trading derivatives, it's crucial to consider the fair value of the contract, as this helps investors and traders to make informed decisions about whether to buy or sell the contract. However, there are instances when a client may sell a derivative contract at a much lower price than its fair value, and this can be a bad trading strategy if it's done repeatedly.
FCNs consist of an embedded derivative that client is selling to generate the higher coupon. If price that client pay for FCN is much higher than fair value it implies that client is overpaying for an FCN. Derivatives underlying an FCN is priced based on equity derivatives market where participants are sophisticated players like investment banks, hedge funds etc. Consistently paying a huge amount of fees on FCNs can be a recipe to lose money in the long run. In a repeat game, this fees becomes material and will in itself the soundness of the FCN investment strategy.
Consistently selling a derivative at a much lower price than its fair value can also signal a lack of understanding of market dynamics and a failure to properly assess the risks and rewards of the trade. It can be an indication that the client is not properly pricing the derivative based on the underlying asset's price, time to expiration, and volatility. This can result in losses that could have been avoided by more careful analysis of the market and the derivative's fair value.
Consistently selling derivatives at much lower prices than their fair value can result in missed opportunities to generate income. If a client is selling derivatives at prices that are far below their fair value, they may be missing out on opportunities to earn income from the trades. This can result in a significant loss of potential revenue over time.
