Derivatives derive their value from another asset and their fair value is an objective measure of their worth, often calculated using the Black-Scholes formula. Companies must follow principles when listing fair value on their balance sheet.
A derivative is a financial instrument that derives its value from another asset. Fair value is an attempt to put a target price on a financial instrument, instead of or in the absence of its current market price. Calculating the fair value of derivatives involves taking into account the factors that affect the probability that the derivative will be beneficial to the holder. A company that lists the fair value of derivatives on its balance sheet must follow certain principles, such as tracking the value of the underlying asset.
There is a wide variety of derivatives available. They generally involve an agreement to carry out an exchange in the future, although one of the parties may have the option to decide whether the agreement continues. In each case, the terms of the exchange are based on the price or exchange rate of a separate asset that can, and generally will, change between the derivative agreement that is entered into and the date of the agreed exchange. One or both parties to the derivative agreement can sell the rights to complete the agreement, known as selling a position. In other words, the derivative is an asset in its own right, complete with a market price.
The fair value of derivatives is not necessarily the same as their current market price. Instead, it is an attempt to give an objective measure of what the position in the derivative is actually worth holding, which may differ from the price at which it is sold. Most methods of measuring fair value use an objective formula, although deciding which factors to include in the formula is itself subjective.
One of the most common examples of a formula for measuring the fair value of derivatives is the Black-Schole formula. This formula takes into account the current price of the underlying asset, the degree to which this price has fluctuated in the past, the terms of the derivative, the time remaining until the derivative’s exchange expiration, and the current rate of return available on risk. -free investments like government bonds. Most attempts to assess the fair value of derivatives use factors similar to this one.
There are two main reasons for calculating the fair value of derivatives. The first is to compare this with the current market price. If the current market price is lower, the investor may conclude that it is a good value investment that is more likely to end up financially valuable. A second reason is to produce a value for the derivative to be used by including it as an asset on a balance sheet. There are complicated rules for how companies must do this calculation, depending both on the accounting regulations to which the company belongs and on the type of derivative in question.
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