The basic principle of pricing or valuation of any asset is to determine the present value of all the future expected cash flow from the asset. In determining the present value we need to determine the rate at which such stream of cash flow is discounted. The discount rate so selected should eliminate all the possibilities and impact of risk on the asset.
In this chapter, we discuss the basic principles based on which the derivatives are priced, how and what should be the price of the derivatives at its initiation, lifetime and at the expiration of the contract, what are the costs and the benefits of holding an asset that increases/decreases its values, differences in valuing the different types of derivatives, the concept of call-put parity and American and European option.