Financial instrument valuation in Singapore
The purpose of this article is to provide a brief introduction to some of the key concepts in financial instruments and their valuation.
Probably you might have heard of the term “financial instrument”. But what are they? Financial instruments are actually shares, bonds, derivatives and other securities that represent some kind of investment. Basically, these instruments are agreements or contracts for monetary assets which can be purchased, created, settled, or modified. While financial instruments are structured in various ways, depending on the parties and transaction. So, how are financial instruments priced? Financial instrument valuation in Singapore is a process of determining the value of the financial instrument. The purpose of this article is to provide a brief introduction to some of the key concepts in financial instruments and their valuation.
Financial instrument valuation
In general terms, valuation is the process that estimates how much a particular asset is worth or valued in monetary terms. While in the context of financial instruments, assigning a price to a financial instrument is called financial instrument valuation. There are various methods, approaches, and techniques that are used to value financial instruments. Since each financial instrument’s data is usually not standard, each method has its own criteria, assumptions and objectivity. However, before moving to the valuation process of financial instruments, let us first understand the concept of financial instruments.
What is a financial instrument?
Financial instruments, in general, can be defined as a set of contracts between parties, the contracts are structured to transfer the ownership of financial products (assets), and they are usually settled by a transfer of cash or some other monetary asset. As such, any asset that holds capital value and can be traded within the company, in the case of a privately held company, is called a financial instrument. It includes, but is not limited to, shares, bonds, mutual funds and derivatives.
Types of financial instruments
In privately held companies, the types of financial instruments can be classified into different asset classes. Here are a few types of financial instruments:
- Equities – Equities are classified into two types: common stock and preferred stock. They are shares or stock in the ownership of the company which represents the equity stake in the company. Sometimes, common stock is referred to as ordinary shares and they have voting rights. On the other hand, preferred stock is usually a security whose voting rights are restricted. However, the dividend is paid first to preferred shareholders.
- Fixed Income – Fixed income financial instruments are debt instruments that pay a rate of interest on a set schedule. It is an agreement to lend money for interest, just like a fixed deposit. Certificates of deposit, corporate bonds, municipal bonds, and treasury bonds are all examples of fixed-income instruments. While governments, corporations, or banks are the entities that usually issue fixed-income instruments.
- Cash equivalent – Cash equivalent financial instruments can be defined as short-term, highly liquid investments that are readily convertible to known amounts of cash. Examples of this type of financial instruments include short-term treasury bills, bank certificates of deposit, bankers’ acceptances, and corporate commercial paper. As a result, cash equivalents are easily converted to cash, they are subject to very low risk.
- Financial derivatives – Financial derivatives are financial products that derive their value from another financial instrument or an underlying asset. These derivatives are contracts between two parties that are brought and settled after a certain period at a predetermined price. Examples of these types of financial instruments include swaps, forward contracts, futures contracts and options.
- Private equity – Private equity is an instrument usually with both equity and debt characteristics. However, in most cases, investors provide capital and in return, the investors receive an ownership stake in the company where they invest. Private equity firms, angel investors, and venture capital firms are some of the investors who are involved in private equity.
Methods to value financial instruments
Now that we understand the basic concepts of financial instruments let’s go through the financial instrument valuation methods. There are mainly three approaches to financial instrument valuation used by companies and institutions, the income approach, the market approach and the cost-based approach. Following is a brief description of each approach:
- Income approach – In the income approach, the value of a financial instrument is estimated by calculating the present value of its cash flows. The future cash flows may be in the form of fixed interest, dividends or payments under a servicing agreement. At the same time, a discount rate is used to measure the present value of future estimated returns or cash flows based on the instrument. It is essential to note that realistic assumptions and projections should be drawn according to the potential of the instrument in order to reach at more accurate values. Black-Scholes-Merton, a binomial model and similar other pricing are a few examples of the income approach.
- Market approach – The market approach involves determining the value of the financial instrument by comparing it with similar or identical instruments. Unlike public companies, privately held companies are not listed on stock exchanges, thus, they have limited access to the market. This results in the absence of comparable market data, which in turn may lead to the use of indirect methods for the comparison. As a result, comparable pricing or private transaction pricing can be used as a method to value financial instruments in private companies where market data is not available.
- Cost-based approach – The cost-based approach is used for financial instrument valuation that involves determining the value of a financial instrument using its historical costs or its replacement cost or reproduction cost. Usually, based on the service capability of the asset, an estimation of the reproduction cost should be made; thus, the financial instrument’s value should be determined. However, it is important to note that this method requires an intense and in-depth understanding of the subject asset to arrive at the appropriate value of the financial instrument.
Therefore, as you can notice, there is no single approach for financial instrument valuation. Depending on the financial instrument, its functionality, contractual terms and other factors, different methods can be applied to determine the value of the financial instrument. It is best to use all three approaches mentioned above to arrive at more accurate values.
How to choose the right financial instrument valuation method for you?
Well, the choice of financial instrument valuation method depends on many different factors. In this section, we will discuss the factors that must be considered in order to properly choose the right method for the valuation of a financial instrument:
- Consider all the terms and conditions – In order to determine the best method for the valuation of a financial instrument, you should be aware of all the terms and conditions that apply to the instrument. You must look at the details provided in the contract of the instrument in order to determine the most effective way to estimate the value of the financial instrument.
- Consider a goal of valuation – There are several reasons why you must determine the value of a financial instrument. As such, you should determine the purpose and objective of the valuation and then choose the best method to be used. Typically, the method you select should be consistent with your goal of valuation, as well as, it should be the most appropriate method in terms of metrics and inputs required.
- Significance of framework – The control environment in which the business and the instrument function must also be taken into consideration when choosing the best valuation technique. The control environment includes internal governance, procedures, and operating efficiency. Thus, in order to arrive at the most appropriate results, you must determine the level of management control, as well as, the relevant inputs required.
Get expert help with your financial instrument valuation with Eqvista!
Now that we have given an overview of financial instruments and their proper valuation methods, you must have noticed that valuing financial instruments requires a lot of expertise and knowledge. This makes it important to seek the services of a professional in order to ensure that the valuation process is effective. Eqvista is here to help you get a reliable and cost-effective financial instrument valuation. The team of experts at Eqvista will analyze and assess your financial instrument thoroughly, based on which we will provide you with an accurate and fair valuation report. Contact us to learn more!