Ways to look at Valuation vs Pricing

I would like to share some perspectives to look at valuation vs pricing:

Definition wise

Valuation: Valuation of a portfolio is discounted value of the future cash flows. Accurate knowledge of these cash flows is important, but the future cash flows are assumed to be projected assuming current economic scenarios. Value “quite a lot” depends on utility, and utility is most of the time stable hence value is stable. It is assumed that whatever the relationship portfolio holds with the external factors today will hold good in down the line in future.

Pricing: Price as discussed, depends on current demand and supply, which is very much dependent on the current circumstances.

Held for Sale and Held for Maturity wise

In the most simplest term, assume we have bought a new car. The car’s price is 20,000 dollars.

From pricing perspective: Once we get out of the showroom and try to sell the car, it won’t be worth 20,000 dollars. Because once the car is out of showroom any new buyer will consider two scenarios, first the car has some defect, second that car is perfect. Each scenario will have some probability, so from the risk neutral perspective he would like to get some discount in the money he pays for the car to be indifferent from the risk that the car has a defect.

From valuation perspective: If we do not intend to sell the car, its value is still 20,000 dollars for us. Because we need the car and if it is taken away from us we would need to replace the car and again the original car will be 20,000 dollars. Also we know the car is perfect so from our perspective because we know its history, so we would consider the car to be 20,000 dollars.

Value and price in the context of financial derivatives

Another way to look at price and valuation is comparing the model prices (~value) and the actual prices.

Models in risk and front-office systems use certified methodologies for pricing of financial instruments. However, while models prices act as a benchmark, market prices are only finalized after rigorous negotiations. The level of urgency and the current demand/supply play an important part in the final negotiated price, which may not reflect the observed market parameters a model may be using for pricing.

Pricing systems use data from market data providers to price the securities in the portfolio, but there are two major limitations on the data provided by them: (1) they try to capture all the known deals in the market, and provide market parameters based on this information; and (2) the market parameters depend on an immediate amount of demand and supply, which may not be reflective of a bank’s portfolio size while marking the portfolio to the market

Regarding the first limitation, to keep themselves competitive, banks often do not disclose the deals they are providing to their prime customers. So, even though the reach of data providers in the market is deep, they still do not have complete knowledge of the market.

The second limitation, meanwhile, makes it challenging for market participants to know the exact price of an existing security, unless a bank decides to go to the market to sell/buy it. Indeed, there is a fair chance that the realized price of an instrument will differ from the model price.

I will keep updating this discussion as I collect/understand/gather more insights.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s