Theoretical Value
Theoretical value is the estimated fair price of a financial asset, such as an option, stock, or bond, based on mathematical models and market factors. It helps traders and investors determine whether an asset is overpriced or underpriced compared to its current market value.
How Theoretical Value is Calculated:
- For Options: Models like the Black-Scholes model or Binomial pricing model estimate an option’s fair price based on factors like strike price, time to expiration, volatility, and interest rates.
- For Stocks: Fundamental analysis using metrics like discounted cash flow (DCF) helps determine a stock’s intrinsic value.
- For Bonds: Theoretical value is calculated using present value formulas, factoring in interest rates and future cash flows.
Why It Matters:
- Helps traders spot mispriced assets for arbitrage opportunities.
- Aids investors in making informed decisions rather than relying solely on market prices.
- Used in risk management to assess fair valuations.
While theoretical value provides a pricing benchmark, market conditions, supply and demand, and investor sentiment can cause actual prices to deviate from theoretical estimates.