Complex Financial Instruments
Valuation of Financial Instruments – What Are They
Financial instruments are contracts that are expected to provide some financial benefits now or in the future. For some instruments such as bonds, financial benefits like the payment of an interest and the return of principal are legally binding and can be enforced in court. For other instruments such as stocks, financial benefits of dividends and capital appreciation might only be expected. In addition to bonds and stocks, other financial instruments include futures, options, swaps and convertible debt. These instruments are widely used by investors and companies in order to invest capital profitably or to manage various risks such as inflation.
Why Valuing Complex Financial Instruments Requires Expertise
Valuing complex financial instruments requires a high level of expertise and experience. These instruments often involve unique or complex features and risks that can make them challenging to value accurately or easily. For example, a convertible debt instrument has features of both a bond and an option on a stock. As a result, both features need to be valued separately in order to arrive at an appropriate valuation. Furthermore, when the instruments are thinly traded, the valuation process can become even more complex since one might not be able to rely on market data in such a case and will then require other approaches for valuation such as simulation.
Additionally, market data and economic conditions can change rapidly, further complicating the valuation process. As a result, it’s essential to work with a business valuation firm that has a deep level of understanding of the instruments makeup and the ability to apply advanced valuation techniques correctly, and using advanced, sophisticated modelling, such as simulations to provide reliable and accurate valuations.
Our Approach to Valuing Complex Financial Instruments
In light of the complexity of various financial instruments and the potential for cookie cutter methods to materially mis-value such instruments, our process focuses on the use of methodologies customized and adapted to each client’s instruments. For example, we might apply the Black Scholes option pricing model to value options for a liquid stock of a large company. However, we will develop non-linear Monte Carlo simulation to price options for a small, thinly traded stock of a small company since the assumptions of the Black Scholes model are not relevant for such a stock and will therefore likely result in material errors in valuation.
Who Needs Valuations for Complex Financial Instruments?
To identify who needs financial instruments valued, it is best to start with why they need to be valued. The most common reason is for financial reporting purposes. Like any asset, liability or equity of the subject company, such instruments need to be reported on the balance sheet. They also need to be identified in the organization’s financial position to various stakeholders, including investors, lenders, regulators, and other interested parties. Those that hold or trade financial instruments are required to report them, often on an annual basis, triggering a valuation. Other reasons can include risk advisory, financial due diligence, liquidations, disputes, regulatory investigations or litigation.
From the reasons why financial instruments are required to be valued, it is easy to see who requires them to be valued, such as:
- Hedge funds, investment banks, and private equity firms that invest in these instruments.
- Companies, both publicly listed and privately held, that issue these instruments and need to provide fair value measurements for accounting purposes.
- Lawyers and accountants who require expert valuations for litigation or other legal purposes.
- Auditors who require expert valuations to support their audit opinions on financial statements or other assurance engagements.
Fair Value Measurements of Financial Instruments for Accounting Purposes
For companies that issue complex financial instruments, fair value measurements are required for accounting purposes under the Generally Accepted Accounting Principles (GAAP). The main standard that applies to the valuation of financial instruments is ASC 820 (Fair Value Measurement).
In addition to ASC 820, other standards may also be relevant depending on the specific type of instrument and the nature of the transaction, including:
- ASC 825 (Financial Instruments)
- ASC 815 (Derivatives and Hedging),
- IFRS 13, and
- IFRS 9 (Financial Instruments),
These measurements must be performed by an independent third-party valuation specialist with expertise in complex financial instruments.
InteleK’s expert appraisers in this space are working with auditors, private equity firms, listed companies, and attorneys to deliver highly defensible conclusions of value from deep level knowledge and application of advanced and sophisticated techniques and technology, backed by academic rigor and real-world insights. If you have a valuation matter concerning complex financial instruments, please make contact with one of our accredited appraisers.