If you`re involved in finance, or even just interested in it, you may have come across the term “forward volatility agreement” (FVA). Essentially, an FVA is a financial instrument that allows two parties to agree on a future price for a security while also setting the terms for how they will handle the associated volatility risk between now and the agreed-upon date.
But how do you actually price an FVA? Here are some key factors to consider:
1. Underlying asset: The first thing to consider when pricing an FVA is the underlying asset, or the security that the agreement is based on. For example, if you`re pricing an FVA for Apple stock, you`ll need to look at the current price of the stock as well as any expected changes to that price in the future.
2. Implied volatility: Implied volatility is a measure of how much the market expects a security`s price to fluctuate over a certain period of time. In the context of an FVA, implied volatility can help you determine how much of a premium the buyer of the agreement should pay in order to compensate the seller for taking on the volatility risk.
3. Time horizon: Another key factor when pricing an FVA is the time horizon, or the period of time between now and the agreed-upon date for the security`s price. Generally speaking, the longer the time horizon, the greater the risk of volatility and the higher the premium the buyer should pay.
4. Interest rates: Interest rates can also play a role in FVA pricing. For example, if interest rates are expected to rise between now and the FVA`s expiration date, the seller may require a higher premium in order to compensate for the lost opportunity cost of tying up their money during that time.
5. Counterparty credit risk: Finally, it`s important to consider the creditworthiness of the two parties involved in the FVA. If one party is seen as particularly risky, the other party may require a higher premium to compensate for the added risk of default.
All of these factors can be combined using complex mathematical models to arrive at a fair price for an FVA. While the process may seem daunting, it`s important to remember that the ultimate goal is to find a price that is mutually beneficial for both parties and allows them to manage their volatility risk in a way that fits their individual needs.