The issuance of securities and many merger and acquisition transactions involve derivatives which must be valued for financial reporting or tax purposes.
For derivatives valuation, the income, market, and cost valuation approaches are not applicable, since the underlying asset (such as a stock) is not being valued, nor is an income-generating asset being “rebuilt” at the equivalent utility, as with the cost approach. In the valuation of derivatives, our analysis can involve option pricing models as well as custom Monte Carlo simulations, using random samplings of inputs to obtain a distribution of potential outcomes and value.
In general, ASC 820 encourages reliance on market data when available instead of models in order to reduce model risk. Where models are necessary, reducing model risk relies on the use of proper inputs, as small changes in such inputs can lead to materially different results. Inappropriate assumptions can by themselves create significant model risk, reducing the validity of valuation. For example, the use of a normal distribution, which assumes that extreme events are rare and small, is often inappropriate for many stock option models, especially for many small and illiquid stocks. In such cases, either fat-tailed distributions which better capture the impacts of extreme events—such as a t-distribution—or simulations of future price paths, using actual historical data that already embed regular and fat-tail events, should be used.
Volatility inputs for models should also be carefully considered. For an illiquid stock, such volatility will be materially understated due to the lack of regular, sizable trading; these stock returns should be “unsmoothed”—filtered through an algorithm to account for survivorship and selection biases and infrequent trading, which tend to understate risk and overstate returns—in order to arrive at a realistic volatility level. Moreover, the time window and interest rates used in simulation should be carefully considered; small changes in either or both of these variables can have a substantial impact on the accuracy of the model.
Derivative Valuation Services Tailored To Your Company’s Unique Needs
Whatever the circumstances, Valentiam has the expertise to provide accurate and defensible derivative values. Our finance professionals are experienced in developing customized valuation models depending on your needs, and in calculating supportable inputs to value derivatives. We also have extensive experience in dispute resolution, and have provided expert testimony in many cases involving litigation. Get in touch to learn more about our derivative valuation services.