Valuation Of Instruments Research Articles

Impact of the new International Accounting Standards on the financial statements

The new accounting principles adopted by the IASB will lead to the introduction of increased volatility in the profit and loss account and in the shareholder's equity of banks. The presentation of the net result and of the variations in equity not coming from shareholders' operations in the same profit and loss schedule will also increase this phenomena and will reduce the visibility in terms of understanding the performance of the various activities of the enterprise. This evolution will not enhance the comparability between the financial statements of banks nor the pertinence of the financial information. The principles adopted regarding the valuation of financial instruments are to the detriment of the stability of the results and the principle of prudence, favouring instantaneous valuation without improving the conditions for neither financial information preparation nor the quality of such information. These principles will in no doubt have an influence on how banks manage their interest rate exposure leading to a process of reduction of risks. JEL classifications : G21, M41

Credit Risk Analysis of Mortgage Loans: An Application to the Italian Market

The valuation of financial instruments in which both credit risk and interest rate risk are taken into account is an outstanding task for financial institutions. In this paper, we propose an affine-reduced model to deal with this topic. We show that this model offers analytical tractability as well as richness and flexibility. We also show that the parameters of the model can be estimated via maximum likelihood in a straightforward way. To outline the procedure, we estimate the model on Italian data.

Evaluation of the FASB's Proposed Accounting for Financial Instruments with Characteristics of Liabilities, Equity, or Both

INTRODUCTION The October 27, 2000 FASB Exposure Draft, Accounting for Financial Instruments with Characteristics of Liabilities, Equity, or Both, (hereafter the ED) provides criteria for classifying financing instruments--financial instruments used for financing purposes--or their components as either liabilities or equity on firms' balance sheets. It responds to the fact that financing instruments and firms' capital structures have become so complex that firms' balance sheet classifications of these instruments are conceptually problematic and cross-sectionally inconsistent. For example, some firms classify complex financing instruments, such as mandatorily redeemable preferred stock, in the between the liability and equity sections of the balance sheet, while others classify the same instruments as liabilities or equity. Because the mezzanine is not acknowledged in current accounting concepts or standards, its meaning is vague and its use inconsistent. The Committee supports the FASB's development of standar ds to classify financing instruments in a consistent and conceptually sound fashion. However, we also recognize that this task involves various difficult conceptual and practical issues. This article discusses these issues and makes recommendations. To highlight the distinct classification and valuation issues across different types of instruments, we distinguish and define below the following classes of financing instruments: * Simple * Compound, with: * separable components * inseparable components * Hybrid The most difficult issues arise with inseparable compound and hybrid financing instruments. A simple financing instrument has a single component that is either straight debt or common equity. A compound financing instrument consists of multiple components; at least one is a liability and one is equity. The components of a compound financing instrument may be separable, meaning that the components can be independently valued through their lives. A bond with an attached warrant is a separable compound financing instrument. Alternatively, when the components of a compound financing instrument are inseparable, the instrument has liability and equity components that can be defined separately for valuation purposes, but the instrument's ultimate payoff is either as a liability or as equity, not both. Convertible debt is an inseparable compound financing instrument. A hybrid financing instrument has characteristics of a liability and equity but does not have distinct components that are straight debt or common equity. Preferred stock is a hybrid instrument. This article summarizes the Committee's four main comments on the ED. (1) 1) The ED classifies most complex financing instruments as liabilities, yielding a very heterogeneous set of liabilities and an artificially narrow set of equities. This decreases the usefulness of the balance sheet both for assessing a firm's solvency and for valuing its residual claims. 2) The ED does not clearly link the classification of financing instruments on the balance sheet to the related costs on the income statement, rendering analysis of the two financial statements through ratios such as return on equity difficult. 3) The ED's classification of hybrid and inseparable compound financing instruments relies on contractual provisions such as mandatory redemption rather than economic substance. 4) The ED bases the valuation of inseparable compound instruments on the relative fair values of the components, with embedded options valued incrementally above the value of the host instrument. This approach does not properly reflect the following two factors: a) the probabilities that these instruments will be settled as debt or equity, and b) the joint values of multiple, interacting options. Because reliable valuation is generally difficult for inseparable compound financing instruments, expanded measurement guidance is needed. …

Physics in finance

These days it is not unusual to find people with a PhD in physics on the trading floor of a bank, but seven years ago such folk were very rare. This article is about what happens when a physicist works on the trading floor; not only the financial mathematics and research but also the people and the situations that he or she encounters. It is partly biographical, beginning with the description of the research at the Clarendon Laboratory that the author was involved in, and describing how she ended up working for a bank. Various aspects of the finance research that she now pursues are explained, starting with simple foreign exchange rate calculations, going on to discuss some subtle aspects of the Black?Scholes model used in the valuation of financial instruments, and concluding with study on the fair price of options which illustrates how important it is to apply the research methods learnt in physics to the world of finance.

An Approach to Credit Risk Valuation for Structured and Project Finance Transactions

This article presents an approach to loan valuation under credit risk in the case of single-asset firms (project finance, asset-backed securitizations, venture capital, etc.). The methodology draws on the Merton approach of a contingent claim model for valuation of credit risk, whereby the firm9s liabilities (from the most senior debt to subordinated convertible debt and ultimately to equity) are viewed as contingent claims issued against the firm9s underlying assets. The creditors, by extending a loan to the company, implicitly sell a put option to shareholders giving them the right to put the assets of the firm to creditors in case of default. The approach allows the valuation of risky credit debt instruments taking into account their ranking in the cash waterfall, that is, their seniority level. Given the probability distribution of the market value of the assets, the necessary risk premium as well as the related endogenous default probabilities and recovery rates are derived for each tranche of funding.

Simplified Valuation of Single-Payoff Financial Instruments

Cheung and Chung (1996) presented a set of four basic components that can be used to reconstruct piecewise linear payoff diagrams associated with single-payoff instruments. Arbitrage arguments indicate that this provides a method to value complex financial instruments as the sum of the values of their underlying basic components. We present a modified scheme using two hybrid components which were constructed so that each piecewise linear segment can be replicated independently. This leads to a simple algorithm that is amenable to quick computer implementation.

The Varieties of Ecological Piety

AbstractThe idea of nature's sacrality, contrasting starkly with industrial modernity's overwhelmingly instrumental valuation of non-human nature, visibly inform philosophical positions such as deep ecology and Gaia theory. But at a more unspoken level they can also be seen as suffusing a wider societal sensibility, evident not least in popular values regarding nature. But, granted that many people would ascribe such a value to nature, how are such beliefs embodied in their lives? An attention to the theological or cosmological level can only take us so far in understanding the dynamics of culture; we need also to attend to questions of practice, ritual, community and relationship, for it is through such elements that more abstract ideas about humanity's place in the universe are given both support and expression. It is in this spirit of inquiry that this paper proceeds, arguing that religious forms of action and corporateness characteristic of monastic, sectarian, churchly, and folk religiosity have shaped the way that contemporary environmental values are embodied in the practices and experience of everyday life.

Derivatives: a comprehensive resource for options, futures, interest rate swaps, and mortgage securities

Part 1 Options: stock option basics the institutional environment for stock options stock option pricing risk management of an option portfolio option products exotic option - option innovations to meet special needs interest rate options option references and suggested readings. Part 2 Financial futures: contract characteristics and the institutional environment pricing futures, forwards and options on futures - general considerations treasury bill futures Eurodollars US treasury bond and notes futures the Standard and Poor's 500 stock price index futures contract futures references and suggested readings. Part 3 Interest rate swaps/basics: swap pricing and hedging non-generic swaps options on swaps interest rate swap references and suggested readings. Part 4 Mortgage derivatives: the underlying instruments and market characteristics valuation and hedging of MPTs CMOs, STRIPs and other mortgage derivative instruments mortgage derivative references and suggested readings.

Valuation of complex financial instruments via basic components

This article presents a graphical approach to measuring financial instruments. It observes that the payoff contingencies of a large number of single-payoff financial instruments can be reduced to a piecewise-linear cash flow, which can be replicated with a handful of basic building blocks. Four such building blocks are identified, and they all relate to the concept of options. To demonstrate, this method is used to value several financial instruments: truncated standard call options, truncated standard put options, truncated binary call options, and hybrid foreign-currency put options.

Default Risk, Firm Characteristics, and the Valuation of Variable-Rate Debt Instruments

This paper extends the valuation framework developed by Ramaswamy and Sundaresan (1986) to examine the relationship between the risk premium on corporate issues of variable-rate, or floating-rate, debt instruments, and the issuer's risk of default. The investor's expected loss on default of any issue is modeled as a call option written on the stochastic values of future bond payments and the firm's value. Evidence from a sample of 154 U.S. corporate floaters issued over the period 1978 to 1991 shows that investors demand significantly lower risk premiums when positive and large correlations between the issuing firm's operating cash flows and index interest rates are present. There is also evidence concerning the existence of some structural differences in risk premiums based on the issuer's industry and the types of indices used. The impact of callability / puttability and several other market and firm-specific variables are also tested.

A Clarification of the Concept of “Instrumental Valuation” in Institutional Economics

(1992). A Clarification of the Concept of “Instrumental Valuation” in Institutional Economics. Journal of Economic Issues: Vol. 26, No. 1, pp. 197-208.

Financial Simulations On a Massively Parallel Connection Machine

The valuation of complex financial instruments that ap pear in the banking and insurance industries requires simulations of their cashflow behavior in a volatile in terest rate environment. These simulations are complex and computationally intensive. Their use, thus far, has been limited to intra-day analysis and planning. Re searchers at the Wharton School and Thinking Machines Corporation have developed model formulations for massively parallel architectures, like the Connection Ma chine CM-2. A library of financial modeling primitives has been designed and used to implement a model for the valuation of mortgage-backed securities. Analyzing a portfolio of these securities—which would require 2 days on a large mainframe—is carried out in 1 hour on a CM-2a. The valuation of a single security is carried out in real time (1-2 sec). It has been possible to design an interactive system that carries out sensitivity analysis, compares securities, or changes the assumptions of the model, and display the result under direct control from an analyst.

Market Discipline and Bank Subordinated Debt: Note

A lengthy literature in banking has addressed the question of whether the market prices of liabilities respond to individual bank risk-taking activity, that is, whether any ;;market disciplines' exists. However, despite the obvious importance of this question the current record has led to no consensus on the issue. Results have been contradictory. In this Journal alone Hannan and Hanweck (1988) conclude that the market does extract at least some price for risk-taking, while Avery, Belton, and Goldberg (1988) find no such evidence. In this study we argue that this line of inquiry has a serious f law in that it fails to use theoretical models of bank instrument valuation to determine the appropriate testing of market discipline. Therefore, the empirical models have lacked the necessary exactness to isolate the appropriate null hypotheses. To redress this shortcoming and advance the methodology of this area of the literature, we use a pricing model which comes to the banking area from the options pricing literature to look at the yield spread on bank liabilities. Using this model it is clear that the value of large, uninsured, bank liabilities cannot be described as a linear, monotonic, function of risk. Moreover, current bank regulation affects the assumed role risk measures play in the pricing of such debt instruments. Both of these complications mean that simple regressions are not likely to adequately address the relationship between the value of debt and underlying risk. In the final section we empirically investigate the presence of market discipline using contingent claims pricing. We find that accounting measures of bank risk still have little predictive value in explaining yield spreads, and therefore, offer little evidence of meaningful market discipline.

The Evaluation of Debt Exchanges

An approach is presented for analyzing debt-for-debt exchanges from the perspective of the exchange`s impact on the country`s contractual obligations and from the perspective of the creditors whose participation is sought. A general model is developed for valuing partially guaranteed debt instruments and an intuitive motivation is suggested for upper and lower bounds on the valuation of instruments carrying specific as well as rolling guarantees. An appendix presents several easily employed rules of thumb which have been suggested in the literature for valuing collateralized instruments and for estimating the possible net debt reduction achievable through their issuance.

Instrumental Valuation: The Normative Compass of Institutional Economics

(1987). Instrumental Valuation: The Normative Compass of Institutional Economics. Journal of Economic Issues: Vol. 21, No. 3, pp. 1117-1143.

The valuation of floating-rate instruments

A framework for valuing floating-rate notes is developed to examine the effects of (1) lags in the coupon formula, (2) special contractual features and (3) default risk. Evidence from a sample of floaters indicates they sold at significant discounts. While lags in the coupon formulas and other contractual features make these notes more variable, they do not account for the magnitude of the discounts. We conclude that the fixed default premium in the coupon formula of a typical note is inadequate to compensate for time-varying default premiums demanded by investors, who treat other corporate short-term paper as close substitutes.

OPTIMAL INITIATION OF BANKRUPTCY PROCEEDINGS BY DEBT HOLDERS

WHILE THE IMPACT of bankruptcy costs on the value of the firm has been examined in several ways,1 no one has examined it from the standpoint of debt holders.2 In this paper, a state-preference model is employed to determine whether or not bankruptcy proceedings should be initiated by creditors and the optimal timing of such proceedings. Both single-period and multi-period situations are considered. We begin by assuming that bankruptcy may be forced whenever the firm involved is unable to meet its principal or interest obligations. We then consider other conditions, (protective covenants), under which default can be triggered. By concentrating on the valuation of debt instruments in a market context, new insights are possible in an area which heretofore has lacked systematic and rigorous decision rules.