Price versus value of a derivative contract
Question
What does it mean to speak of the value of a contract, as distinct from its price?
Short answer
Price is what the market charges; value is what a model, a hedging strategy or a particular investor says the contract is worth. In complete markets they coincide via replication. Otherwise value depends on assumptions: model parameters, risk preferences, hedging costs, funding and how the holder intends to manage it, so different participants may legitimately value the same contract differently, which is why trades happen.
Adapted from Wilmott, Frequently Asked Questions in Quantitative Finance, FAQ 40, p.188; question and answer rewritten by SelfMadeQuant.com.
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Open the worked solutionLessons behind this question
- Market Model and Risk-Neutral Valuation
- Option Mechanics: Calls, Puts, Moneyness, Intrinsic Value, and Exchange vs. OTC Markets
- Option Trading Strategies: Spreads, Combinations, and Payoff Engineering
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