H7: The use of a derivative security
will precede poor stock price performance.
Since the derivative security
is valued relative to its underlying asset, and can be replicated to form a risk-free hedge, it must have the same value in actual financial markets as in a risk-neutral world.
The valuation equations for a derivative security
in the presence of information costs
(1) The theoretical pricing model is inadequate or inaccurate, which implies that the observed market price may very well be the true price of the derivative security
A derivative security
has contractually determined payouts that can be described by functions of observable asset prices and time.
The value V of a derivative security
whose underlying stock has current price S, dividend yield [D.sub.0], volatility [Sigma], and risk-free interest rate r satisfies the equation: [differential]V/[differential]t + 1/2 [[Sigma].sup.2] [S.sup.2] [[differential].sup.2]V/[differential][S.sup.2] + (r - [D.sub.0] S [differential]V/[differential]S - rV = 0 Analysts ensure the accuracy and efficiency of models, but because they are highly trained and compensated, they make very expensive programmers.
They introduce the notion of temporal granularity for continuous-time stochastic processes, which allows them to quantify the extent to which discrete-time implementations of continuous-time models can track the payoff of a derivative security
. They show that granularity is a function of the contract specifications of the derivative security
and of the degree of market completeness.
For those acquired or entered into before this date, the taxpayer can avoid mark-to-market treatment if it establishes unambiguously that the NPC or derivative security
was acquired other than in the taxpayer's capacity as a dealer in such securities.
FFIEC should allow the institution to rebut this presumption if it can demonstrate that, when compared to total portfolio investments, the derivative security
reduces total portfolio interest rate risk.