188 Frequently Asked Questions In Quantitative Finance
What is Meant by the ‘Value’ of a
Contract?
Short Answer
Value usually means the theoretical cost of building
up a new contract from simpler products, such as
replicating an option by dynamically buying and selling
stock.
Example
Wheels cost $10 each. A soapbox is $20. How much is a
go-cart? Thevalueis $60.
Long Answer
To many people the value of a contract is what they
see on a screen or comes out of their pricing software.
Matters are actually somewhat more subtle than this.
Let’s work with the above soapbox example.
To the quant thevalueof the go-cart is simply $60, the
cost of the soapbox and four wheels, ignoring nails and
suchlike, and certainly ignoring the cost of manpower
involved in building it.
Are you going to sell the go-cart for $60? I don’t think
so. You’d like to make a profit, so you sell it for $80.
That is thepriceof the go-cart.
Why did someone buy it from you for $80? Clearly the
$80 must be seen by them as being a reasonable amount
to pay. Perhaps they are going to enter a go-carting
competition with a first prize of $200. Without the go-
cart they can’t enter, and they can’t win the $200. The
possibility of winning the prize money means that the
go-cart isworthmore to them than the $80. Maybe they
would have gone as high as $100.
