Review of Quantmve Finance and Accounting, 7 ( 1996): 163 176 ~C, 1996 Kluwer Academic Publishers, Boston Manufactured

m the Netherlands

Valuation of Complex Financial Instruments via Basic Components

JOSEPH K. CHEUNG

Deparmwnt o/Accountant% Hong Kong Polvtechmc Umver~tO;Hung Horn, Hong Kong

RICHARD CHUNG

Department of Finance. Concordla Untver~ttv

Abstract
Th~s article presents a graphLcal approach to measuring fmancml instruments. It observes that the payoff contlngenctes of a large number of single-payoff financial instruments can be reduced to a plecewlse-llnear cash flow, which can be rephcated with a handful of basic building blocks Four such braiding blocks are identified. and they all relate to the concept of options. To demonstrate, th~s method ~s used to value several financial instruments truncated standard call options, truncated standard put options, truncated binary call options, and hybrid foreign-currency put options Key words: financial instruments, braiding blocks, derivatives, options

1. Introduction

In the past decade or so, there has been an explosion ofhigh-tech financial instruments in capital markets worldwide. Commonly referred to as financial engineering, such innovations typically involve assembling complicated contracts by "snapping together" simpler securities such as stocks, bonds, options, forwards, and the like (Smithson, 1987). However, most of these complicated contracts are left as off balance-sheet items because existing accounting standards are largely inadequate for dealing with them. As a reflection of this inadequacy, one out of every two issues published by the U.S. Financial Accounting Standards Board's (FASB) Emerging Issues Task Force addresses problems related to financial instruments (FASB, 1991 ). Of all the accounting problems related to financial instruments, measurement is perhaps most fundamental. When measuring financial instruments, one seeks to determine their market values. However, except for standardized contracts that are publicly traded, market values are largely unavailable and have to be estimated. Accountants and auditors are not ordinarily trained to handle the task of estimation. In light of the potential difficulty encountered and of the fact that compound financial instruments are "synthetically" created, the FASB has proposed a "'building-block'" measurement approach. Namely, a compound instrument is to be stripped into simpler instruments, the building blocks, and the instrument's economic value is to be approximated as the sum of its building blocks'. 1The building-block approach has been chosen primarily because of its intuitive appeal. 2