A general pricing approach

Exotic or not, there is one intrinsic feature that is always the same in every derivative product, that is, it is a function of other instruments, hence the name derivative. Thus, the price of a derivative is not independently developed as the outcome of a direct supply and demand; rather, it is given as an estimated construction cost. For example, the one month forward dollar price of a euro is highly dependent on the spot dollar price of the euro; the forward price is just the function of the spot price (and the interest rates).

If exactly the same benefits that are granted by holding a derivative can be constructed by a trading strategy that involves less complex instruments, then the derivative can be replicated. Derivatives are not like unique paintings; the forgery of a derivative has the very same value, while replicas are as good as the original. By using the no-arbitrage argument, Black and Scholes (1973) and Merton (1973) showed that the price of a derivative...