Complex Securities Valuation (ASC 815)
Complex securities have unique financial features than traditional securities and are closely linked to equity and/or debt instruments. Many complex securities include features that alter payouts over the life of the security, such as options, return multiples, and price performance targets. Such types of securities are often issued in association with incentive compensation, capital raises, and other financial activities. Examples of complex securities include – Equity options, Warrants, Interest rate swaps, Credit derivatives, Convertible bonds, callable and puttable bonds, etc.
Corporate executives are responsible for appropriately valuing complex securities for audit, financial reporting, and tax-related purposes. Appropriate fair valuation of such instruments provides greater insights into the risk of a business and helps various stakeholders make better informed economic decisions.
Following are the most widely used method to determine fair values for Complex securities:
Lattice Model: Complex instruments with the “Early exercise” feature are more suited to be valued using lattice models. Lattice models are discrete valuation models which may include a binomial or trinomial model.
Black Scholes Merton (BSM) Model: BSM closed-form form model is most suitable for European-type options. It is relatively easier to perform valuations using BSM than the other approaches.
Monte Carlo Simulation (MCS): MCS is also widely used to perform complex securities valuation. MCS is the most complex but provides the greatest flexibility to incorporate various features of target securities. MCS is the most preferred method for path-dependent instruments such as mortgage-backed securities (MBS).
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