Derivative valuation

Currently, it is common for companies to use financial instruments to hedge, or speculate on the fall or rise of, the value of the underlying asset. It is not unusual for these financial instruments to include embedded derivatives that cannot initially be easily identified, so a company may not even know that such a financial instrument is present in the host contract.

We recently had a case where our client identified the option, but not the obligation, to buy not only leased immovables, but also their owners (i.e. the companies owning them) in its lease agreements. As this identified embedded derivative met the conditions for being separated from the host contract, it had to be separately measured and recognized. In this case, it was an embedded option.

After discussions with the client, we prepared a valuation model for this option and the client was able to correctly recognize its profit/(loss).