Broadly defined, financial instruments are assets that can be traded, or packages of capital that may be traded. These assets can be cash, a contractual right to deliver or receive cash or another type of financial instrument, or evidence of one’s ownership of an entity.
Financial instruments are generally categorized in two different ways. The first, classifies financial instruments as either cash instruments or derivative instruments (meaning they derive their value from another instrument or underlying security), or they can also be categorized by asset class (meaning they can be viewed as either asset-based or debt-based).
For context, the following are a few examples of various financial instruments:
A stock option is a contract which gives the buyer (the owner or holder of the option) the right, but not the obligation, to buy or sell an underlying asset (in this case a share of stock) at a specified exercise price prior to or on a specified date.
The exercise price may be set by reference to the market price of the underlying security on the day an option is taken out, or it may be fixed at a discount or at a premium. The seller has the corresponding obligation to fulfill the transaction – to sell or buy – if the buyer (owner) “exercises” the option.
Convertible notes can be seen as hybrid instruments; part debt and part equity. They are derivative securities whose value is derived from the value of debt component and equity value on which it ultimately depends. The owner of the convertible note receives periodic coupon payments (like a traditional debt instrument) from the issuer.
Additionally, the holder has the right to convert the debt into a predetermined number of shares prior to the maturity of the note. If the note is not converted, the holder receives the return of the investment in cash plus any additional remaining coupon payments.
The benefit to the holder is that if the value of the underlying stock appreciates such that they are better off converting their debt into shares they are allowed to do so.
If, on the other hand, the underlying stock fails to appreciate to the point where conversion provides the highest payout, the holder simply receives coupon payments and the return of their investment at maturity.
What is the difference between a liability and equity?
Complicating matters further is how the financial instrument is treated for financial reporting or accounting purposes. Despite guidance from the Financial Accounting Standards Board (FASB), it is often unclear whether a financial instrument should be accounted for as a liability (i.e. debt) or equity (i.e. shares).
This distinction is important as it will directly impact a company’s financial statements given that gains or losses on the value of the instrument will be recorded on the income statement. Additionally, changes in fair value will also be reflected on the company’s balance sheet each reporting period.
If accounted for as a financial liability, for example, this will reduce the reported profitability of the company. If treated as equity, this may have a positive impact on the income statement and cash flows of the entity.
How are financial instruments valued?
There are several ways to estimate the fair value of these types of instruments. Stock options, for example, can be valued using either the Black-Scholes formula, lattice models (binomial or trinomial) or via Monte Carlo simulation.
The Black-Scholes formula relies on a series of formulas to estimate the variation over time of a financial instrument. It assumes these instruments (such as stocks or futures) will have a lognormal distribution of prices. Using this assumption and factoring in other important variables, the equation derives the price of a call option.
Lattice models trace the evolution of the option’s key underlying variables in discrete-time. This is done by means of a binomial lattice (tree), for a number of time steps between the valuation and expiration dates. Each node in the lattice represents a possible price of the underlying at a given point in time.
Valuation is performed iteratively, starting at each of the final nodes (those that may be reached at the time of expiration), and then working backwards through the tree towards the first node (valuation date). The value computed at each stage is the value of the option at that point in time. Option valuation using this method is, as described, a three-step process:
1. Price tree generation,
2. Calculation of option value at each final node,
3. Sequential calculation of the option value at each preceding node.
Monte Carlo simulation is used to model the probability of different outcomes in a process that cannot easily be predicted due to the intervention of random variables. Monte Carlo simulation is a particularly useful technique to value financial instruments given that there is often uncertainty in predicting future events or outcomes.
Given the complexities associated with the accounting and valuation of these types of instruments, it may be in your best interest to complete valuation requirements like these with the help of experts who can confidently lead you through the process, and make adjustments as necessary to maximize your results.
If you are interested in learning more about business valuations, or if now is the right time to move forward with one, please reach out to us for a conversation today.
About the Author:
Mark Sadauski, CMA, CVA
Director, Objective Valuation, LLC
15+ Years of Experience
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