Editing Derivative (finance) (section)

===Determining the arbitrage-free price===
{{see also|List of finance topics#Derivatives pricing}}
The arbitrage-free price for a derivatives contract can be complex, and there are many different variables to consider. Arbitrage-free pricing is a central topic of [[financial mathematics]]. For futures/forwards the arbitrage free price is relatively straightforward, involving the price of the underlying together with the cost of carry (income received less interest costs), although there can be complexities.

However, for options and more complex derivatives, pricing involves developing a complex pricing model: understanding the [[stochastic process]] of the price of the underlying asset is often crucial. A key equation for the theoretical [[valuation of options]] is the [[Black–Scholes formula]], which is based on the assumption that the cash flows from a European stock [[Option (finance)|option]] can be replicated by a continuous buying and selling strategy using only the stock. A simplified version of this valuation technique is the [[binomial options model]].

OTC represents the biggest challenge in using models to price derivatives. Since these contracts are not publicly traded, no market price is available to validate the theoretical valuation. Most of the model's results are input-dependent (meaning the final price depends heavily on how we derive the pricing inputs).<ref>{{cite web |last=Boumlouka |first=Makrem  |title=Alternatives in OTC Pricing |work=Hedge Funds Review |date=October 30, 2009 |url=http://www.hedgefundsreview.com/hedge-funds-review/news/1560286/otc-pricing-deal-struck-fitch-solutions-pricing-partners}}</ref>
Therefore, it is common that OTC derivatives are priced by Independent Agents that both counterparties involved in the deal designate upfront (when signing the contract).