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Valuation of Derivatives (Financial Instruments)

Despite their role in the financial market crisis, derivatives continue to enjoy great popularity in corporate practice and increasingly also outside the financial sector. While financial instruments such as loans, promissory notes and so on are used as classic means of refinancing companies, derivatives are often used in the context of risk mitigation. A first step is to focus on the economic hedging of the individual risk types such as market risks (interest rate risk) and credit risks. The next step is to address the question of what extent the company wishes to transfer the instruments into a hedging relationship in the sense of hedge accounting. 

Different Types of Derivatives

In addition to explicit or stand-alone derivatives, these are often also embedded in non-derivative financial instruments in order to adjust the cash flow from the instrument to the needs of the customer or issuer or market requirements. Probably the most common example is an interest limit in the form of an interest floor/interest cap within the framework of loan agreements.

However, derivative structures can also be found in company purchase agreements in which part of the purchase price is frequently paid depending on future events (so-called earn-out clauses) or repurchase rights (tag-along and drag-along rights or repurchase rights) are agreed via derivatives.

Valuation of Derivatives

Whether a non-derivative financial instrument, a stand-alone derivative or an embedded derivative: A valuation in the sense of determining the market price or fair value is necessary for various reasons.

  • Determination of the balance sheet recognition or effect on the income statement
  • Disclosures in the Notes to the Financial Statements (e.g. in accordance with IFRS 7)
  • Risk determination and controlling (e.g. in the course of determining sensitivities)
  • Determination of transaction prices

Naturally, no transaction prices are available for unlisted instruments, which is why they have to be measured using actuarial valuation methods.

Non-derivative instruments are often valued by using the discounted cash flow method. Here too, however, the derivation of market parameters and, in particular, the determination and consideration of credit and counterparty risk can present companies with challenges.

The valuation of derivatives often requires the use of complex actuarial models, such as a standard binomial model for equity derivatives, a trinomial model for barrier options, interest rate models such as the Black 76 or Hull-White models for the valuation of caps/floors and swaptions, and credit models for the valuation of credit derivatives such as call options and credit default swaps. The application of these and other actuarial models often requires not only methodological knowledge but also expertise in technical implementation or programming.

FAS AG Support in the Valuation of Derivatives

We will be pleased to support you in the selection of a suitable evaluation procedure, taking into account cost-benefit aspects, the introduction and implementation as well as the derivation of controlling ideas or recommendations for action.

If you are interested or have any questions, please contact us.

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 Andreas Huthmann Managing Partner