IVSC re-exposes derivative valuation proposals

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02 Sep 2014

The International Valuation Standards Council (IVSC) has issued a revised exposure draft proposing guidance on the valuation of equity derivatives. The revised exposure draft responds to feedback on an earlier exposure draft published in 2013, placing more emphasis on practical considerations, including consideration of derivative strategies, and additional guidance on the applicability of models and resolution methods.

The proposals in the exposure draft, entitled The Valuation of Equity Derivatives, would lead to the publication of a Technical Information Paper (TIP), which would be the first in a series of planned papers providing guidance on the valuation of derivatives in different asset classes, including fixed income, credit, foreign exchange, commodities, asset backed securities and hybrid products. TIPs support the application of the core International Valuation Standards (IVS) published by the IVSC, and are intended to provide information to assist experienced valuers decide which is the best valuation approach in specific situations.

The exposure draft discusses the equity derivatives market, various equity derivative products, and provides specific guidance on the valuation of forwards and futures, swaps and options. The valuation of options are discussed in in three widely used categories of valuation models, being the Black Scholes model and its extensions (assuming equity prices follow a Geometric Brownian Motion), alternative-diffusion models (which treat volatility differently to Black Scholes to more closely match real market volatility) and jump-diffusion models (introducing a 'jumps' in equity prices). It also includes specific sections on valuation sensitivities (the "Greeks"), model resolution, model calibration and input selection, implementation considerations and option valuation models and applicable products.

Changes in the revised exposure draft include:

  • New guidance on derivative strategies, which encompass a combination of derivatives and other assets to achieve a specific investment objective. Examples of such strategies included in the paper include butterflies, collars, covered calls, protective puts and straddles and strangles. The paper proposes that the value of a strategy is the sum of its parts
  • Removal of formulae included in the original exposure draft, in favour of relying on descriptive narratives of concepts. This change reflects concern about the practical problems with formulae, including accounting for relationships that cannot be expressed through concise mathematical expressions, and the objective of TIPs being practical guides rather than academic or training materials
  • New guidance on which derivative valuation models can be applied to different kinds of products, as well as some commonly used techniques of model resolution. Although analytical solutions are preferred, these can only be used for a limited range of products and accordingly other techniques such as Monte Carlo, trees and finite difference are discussed.

The exposure draft is open for comment until 30 November 2014. Click for access to the exposure draft on the IVSC website.

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