What is a Theoretical Value? Definition, Example, Benefits

A theoretical value is the minimum price that a seller will accept for an item. If you know your theoretical value, it is possible to negotiate a higher selling price with a prospective buyer. 

What is a Theoretical Value?

A theoretical value is the expected cost of an option. It is often referred to as a fair or hypothetical value. The price of options may involve purchasing, selling, or a mix of the two. Typically, this number is determined using a certain mathematical equation. There are several similar models now in use.

What is a Theoretical Value?

Understanding Theoretical Value (Of A Right)

In general, the theoretical value and market value of a right are same or fairly comparable. It is also known as the right’s intrinsic worth. Investors are interested in this number because the value of stock shares with attached rights during the cum rights period may differ from the value of normal shares without such rights.

Real-World Example of Theoretical Value of a Right

As an illustration, the current price of a share of stock is $40, the exercise price (or subscription price) is $35, and four rights are necessary to acquire one share. The value of the right in theory is:

($40 – $35) / (4 + 1) = $1.

Approximately three days prior to the expiration date is the exercise of rights period. These are the final days to exercise rights, but it is too early to acquire new shares with rights since the deal will settle before the record date, which is the day the rights expire. During the exercise of rights phase, when rights trade independently of the stock, the theoretical value differs from the value during the cum rights period.

What is a Theoretical Value?

The formula for calculating the value throughout the term of exercise of rights is:

(Stock price – Right subscription price) / Required number of rights to purchase one share.

Continuing with the preceding example, if the stock price during the ex-rights period is $38 and the theoretical value of the right during the exercise rights time is ($38 – $35) / 4 = $0.75, then the theoretical value of the right during the exercise rights period is $0.75.

The value of a right is determined using the same characteristics that are used to price options, including the subscription fee, current interest rates, time to expiration, and the share price of the underlying company, while taking its volatility into account. Due to their very short duration, rights have much less temporal worth than the majority of alternatives.

Benefit Of Theoretical Value

The calculation of the theoretical value is advantageous to investors in several ways. Initially, the assessment of a hypothetical value for the option or options, given certain market conditions, might shed light on whether the acquisition or sale of the asset is prudent.

What is a Theoretical Value?

Obviously, the theoretical value depends on the accuracy of the assumptions made on market performance in general and option performance in particular.

Second, the computation of a theoretical value enables the investor to make performance projections based on a variety of situations.

The Black-Scholes method, along with other mathematically based methods used to estimate theoretical value, permits the use of various figures.

By performing many predictions, the investor may choose the most likely future scenario, while being prepared for the possibility that one or more aspects would differ.

Theoretical Nil Paid Price

If an investor decides to sell his or her right outright on the market or to let the right lapse, which may incur a modest administrative fee, they will get the notional $0 paid price of the right.

This value is determined by calculating the difference between the investor’s subscription price and the theoretical ex-right price. Using the above example, the computation for a potential zero-paid price is as follows: $40 – $38 = $2.

Thus, the amount the investor would receive for the right is double the value of the right during the cum rights period and significantly larger than the value of the right during the ex-rights era.

What is a Theoretical Value?

Conclusion

Theoretical value is one of the most fundamental trading techniques utilized today. By comparing the predicted value to the current market price of an option, it is possible to establish if the purchase or sell is likely to provide a profit in the future.

Before making any form of financial choice, brokers and investors often use this approach.

FAQ

The calculated price at which a security should sell. Depending upon investor expectations and market imperfections, a security may sell at a price above or below its theoretical value.

Alternate Wording. Accepted value is sometimes called the “true” value or “theoretical” value, so you might see the formula written in slightly different ways: PE = (|true value – experimental value| \ true value) x 100%.

The experimental value is your calculated value, and the theoretical value is your known value. A percentage very close to zero means you are very close to your targeted value, which is good.

Amounts of products calculated from the complete reaction of the limiting reagent are called theoretical yields, whereas the amount actually produced of a product is the actual yield. The ratio of actual yield to theoretical yield expressed in percentage is called the percentage yield.
5/5 - (1 vote)
Pat Moriarty
Follow me

Leave a Comment