Complex Financial Instruments

It takes technical proficiency and years of experience to value complex financial instruments.

While not all complex financial instruments (CFI) are hard to value or high risk, most are. Even defining a CFI can be a complex subject. CFIs typically have distinctive features that need to be considered when valuing the security, such as call or put options, market-based vesting criteria or embedded derivatives (which may or may not need to be separately bifurcated and recorded for financial reporting purposes).

Five key characteristics of a CFI important to understand when assessing value:

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  1. Leverage: Understanding the leverage embedded in the structure of a CFI is critical to determining how its value changes over time. Leverage can take several different forms, including: (a) borrowing money to finance the purchase of securities; (b) the use of derivatives; (c) the use of tranches whereby senior tranches are repaid quicker than junior tranches; and (d) nonlinear and payoff structures.
  2. Multiple price paths: A CFI is itself a collection of multiple securities and features bundled together. Therefore, the resulting valuation model must account for the impact of two or more underlying securities and features, simultaneously. This commonly applies to derivative instruments, whose value or payoff at maturity is dependent on the value or outcome of another, underlying asset.
  3. Lack of price transparency: Another characteristic of CFIs is that they typically lack price transparency. Therefore, their valuation will depend on proprietary financial models and the inputs that drive those models will not be observable. Creating a corroborative financial model to validate the price is time consuming, if not very difficult.
  4. Lack of liquidity: CFIs can be illiquid. Therefore, their valuation may have limited evidential support.
  5. Path dependency: The payoff at maturity or exit may be dependent on the periodic outcomes, or path, of an underlying asset price, metric or feature. Therefore, the valuation may require a robust methodology which can incorporate (or simulate) the path, and various outcomes, over time in order to accurately compute the resulting payoff.

RSM’s valuation team has an experienced group of CFI professionals with extensive quantitative and complex modeling capabilities. Our professionals have backgrounds in finance, quantitative finance, mathematics and coding to provide specialized capabilities to meet the needs of our clients.

Inclusive, hands on approach

We have established a consistent, inclusive approach to valuing CFIs, designed to help you understand the impact of each security’s features on the overall instrument’s value. We know CFIs are not only difficult to value, but also difficult to understand. We translate the CFI’s features into a coherent illustration, which we discuss with your team to ensure all parties have the same valuation expectations. Our team values the identified CFI in the most proficient manner while ensuring adherence to the proper accounting standards.

CFIs are valued using complex models, usually involving Monte Carlo simulation, lattice models, code-based solutions or the option pricing model (OPM). Other models such as the probability-weighted expected return method (PWERM) or current value method (CVM) may also be relevant, but are not as frequently applied. As CFIs are unique, and contain individual security features, the models are generally custom built for the specific security at hand.

There are a significant number of assumptions and numerous types of financial models that can be used to determine the value of a complex financial instrument. Selecting assumptions that are not congruent with a market participant's perspective, or application of a financial model that cannot fully capture the instrument’s complexities, may result in incorrect valuation conclusions.

Typically, the accounting classification will indicate guidance for a particular type of CFI and drive the valuation need and selection of methodology. Provided below are some examples of instruments we encounter frequently:

ASC 718 Stock Compensation:

  • Management incentive units (MIUs)
  • Profits interests
  • Stock options and warrants (including those with ratchet, down round or other features)
  • Performance Share Units (PSUs) with market conditions, such as performance relative to a peer group (i.e., total shareholder return (TSR or rTSR)

ASC 480 Distinguishing Liabilities From Equity: Liability warrants

ASC 805 Business Combinations:

  • Contingent consideration (earnouts)
  • Rollover equity in complex capital structures
  • Notes or other financial instruments issued to the seller

ASC 820 Fair Value Measurement:

  • Fixed-rate and floating-rate debt instruments
  • Convertible debt and notes (with or without embedded derivatives and features)
  • Over-the-counter (OTC) derivatives (interest rate, credit, currency, commodity, etc.)
  • Remeasurement of contingent consideration at subsequent reporting dates

ASC 815 Derivatives and Hedging: Hedge effectiveness testing

ASC 842 Leases: Incremental borrowing rate (IBR) analysis

ASC 825 Financial Instruments

ASC 460 Guarantees

Located in offices across the United States, our valuation professionals are well-equipped to meet your specific needs. Our CFI team is on top of the latest technical guidance from accounting standard setters, industry working groups and appraisal societies. We provide valuation opinions that instill confidence that the asset or liability in question is priced appropriately.

Need assistance valuing your most complex assets?

To discuss how our team can help your business, contact us by phone 800.274.3978 or