Financial Instrument Valuation in Hong Kong
Financial instruments are assets that can be traded, or they may be thought of as capital bundles that can be traded.
The demand for financial instrument valuation has been gradually expanding in Hong Kong. With the increase in development of the financial markets, the complexity of financial derivatives also increases. These derivatives are usually used by listed companies for hedging and investment purposes (usually as a result of gaining protection while maintaining upside potential). The growth of the private equity market, aided by PRC funds, encourages investment in non-common equity or a specific type of stock, which results in needing a valuation for fair value reporting. Valuation of these derivatives require careful understanding of the contract terms.
Financial Instrument Valuation
The valuation determines the Fair Value of equity instruments, debt instruments, derivatives (option and future contracts), and embedded derivatives (convertible bonds/preference shares). For commercial, financial reporting, tax, or regulatory purposes, financial instruments may require value.
The amount for which a financial asset or obligation might be exchanged or settled on a particular date between two educated, willing parties in an arm’s length transaction under market conditions is the fair value of that asset or liability on that day. The price that would be paid for a financial asset or liability in an organized, transparent, and deep market (“quoted price” or “market price”) is the most objective and accepted reference for its fair value.
What are Financial Instruments?
Financial instruments are assets that can be traded, or they may be thought of as capital bundles that can be traded. The majority of these allow for the efficient flow and transfer of capital among investors worldwide. Cash, a contractual right to give or receive cash or another sort of financial instrument, or proof of one’s ownership of a business are all examples of assets. A financial instrument is a physical or electronic document that represents a legal agreement involving money.
Types of Financial Instruments
There are two kinds of financial instruments: cash instruments and derivative instruments, which are further explained below:
- Cash Instruments – The markets immediately influence and decide the value of cash instruments. These could be easily transferable securities. Deposits and loans agreed upon by borrowers and lenders are examples of cash instruments.
- Derivative Instruments – The underlying components of derivative instruments, such as assets, interest rates, or indexes, determine their value and features. Because the value of an equity options contract is derived from the underlying stock, it is a derivative. The option offers you the right, but not the responsibility, to purchase or sell a specific stock at a specific price and by a specific date. The option’s value rises and falls in lockstep with the stock price, though not always by the same percentage.
Asset Classes of Financial Instruments
Financial instruments are also classified by asset class, which is determined by whether they are debt-based or equity-based.
- Debts-based Financial Instruments – Short-term debt-based instruments are those that last shorter than a year. T-bills and commercial paper are examples of this type of security. Short-term interest rate futures are an example of exchange-traded derivatives for debt-based financial instruments. Long-term debt-based financial instruments are those that have a maturity of more than a year. There are some bonds that are categorized as securities, loans, and cash equivalents. Bond futures and options on equity are the example options of Bond Future. OTC derivatives include interest rate swaps, interest rate caps and floors, interest rate options, and exotic debentures.
- Equity-based Financial Instruments – This class includes exchange-traded derivatives such as stock options and equity futures. OTC derivatives include stock options and exotic derivatives.
HKFRS 9 Financial Instruments
HKFRS/IFRS 9 was created to improve the relevance and clarity of financial reporting. The reforms implemented by HKFRS 9 are in line with G20, Financial Stability Board, and other requests. The IASB‘s effort to replace HKAS 39 Financial Instruments: Recognition and Measurement brings together the categorization and measurement, impairment, and hedge accounting phases of HKFRS 9. HKFRS 9 is based on a logical, single classification and measurement strategy for financial assets that represent the management model and cash flow characteristics of the assets.
Furthermore, HKFRS 9 addresses the so-called ‘personal credit score’ issue, in which banks and others record gains or losses as a result of the price of their own debt lowering due to a decrease in credit score worthiness after they have opted to the degree of that debt at a fair rate. HKFRS 9 additionally consists of a stepped forward hedge accounting version to hyperlink the economics of threat control with its accounting treatment.
Understanding Financial Instrument Valuation
A financial instrument is any tradable asset, such as currency, evidence of ownership in an organization, or a contractual right to receive or deliver cash or another financial instrument. The valuation of specific financial instruments aids in determining the overall or partial value of a corporation.
Why is it Important to Have Financial Instrument Valuation?
This valuation assists in determining strategies to improve the worth of a company. A valuation may reveal the necessity for a technological investment or the hire of new staff. Perhaps one can realize that an expense can be decreased or eliminated. Valuations are used in conjunction with your strategic business plan and are referred to as a component of any big transaction.
Implications you may get in Financial Instrument Valuation
There are a lot of risks involved while getting the financial instrument valuation; it may face the following difficulties, which are as follows:
- Liquidity Risk – The risk of not being able to acquire or sell an asset quickly is known as liquidity risk. The liquidity of a market is determined by its structure (trading venue or over-the-counter market), as well as the specific instrument because the liquidity of a financial instrument can change over time and is directly related to supply and demand.
- Currency Risk – When a financial instrument is valued in a foreign currency, there is a currency risk. It represents the fact that, depending on the situation, a drop or rise in exchange rates can cause a drop or rise in the price of financial instruments denominated in foreign currencies.
- Interest Rate Risk – Any unfavorable change in interest rates results in interest rate risk. An increase in interest rates reduces the relative value of a financial instrument, particularly a bond.
- Leverage Effect Risk – This risk emerges when exposed to market risk on a nominal notional higher than the original capital (e.g. option premiums or future contracts). Leverage effect risk results in a profit or loss exceeding the initial investment.
- Volatility Risk – Risk associated with the price swings of an investment or a market, whether realized or predicted, is known as volatility risk. High volatility refers to an extensive range of price fluctuations in a financial instrument over a specific time period.
- Possibility of Capital Loss – When the amount initially invested is not fully refunded, a capital loss occurs, especially if the financial instrument has no guarantee or protection or only a partial validation of the capital.
- Underlying Risk of Valuation – Given the unique nature of the underlying asset, the valuation risk of an underlying asset is the risk of receiving a transfer price that differs significantly from the reference valuation.
How to Determine Financial Instrument Valuation
The value of a financial instrument is calculated using the market approach, which considers traded prices in an active market; or prices and other relevant information created by market transactions involving identical or comparable assets.
Project acquisition, planning, term and conditions of financial instruments
When developing a financial plan, you must budget your costs, set aside a portion of your income for savings and investments, and stick to it. After you’ve determined how much of your income you can set aside for savings, you’ll need to select financial products that will suit your needs.
A financial instrument is an asset that holds money and may be traded on the open market. Cheques, stocks, bonds, futures, and options contracts are examples of financial instruments.
An instrument is a device for transferring, holding, or accomplishing something of worth. An instrument is a marketable asset or a negotiable object in finance, such as security, commodity, or derivative.
The Purpose of a Valuation
The goal of a valuation is to measure the success of your strategic decision-making process and to track performance in terms of the estimated change in value rather than just revenue.
Importance of Control Environment
Management and stakeholders can reasonably confirm that the firm is operating in compliance with business policies, industry standards, and legal obligations if the internal control environment is strong.
Methods and Approaches for Financial Instrument Valuation
In financial instrument valuation, there are three methods used by valuation analysts: market approach, asset approach and income approach. These valuation methods are the most commonly used approaches when conducting valuations.
- Market Approach Valuation – Financial executives play a critical role in determining and maintaining a company’s value. Stakeholder and investor returns rise in tandem with a company’s value and vice versa. There are various approaches for calculating the value of a firm. Two of the most frequent valuations are equity value and enterprise value. Both equity value and enterprise value necessitate the use of equity in the calculation.
- Asset Approach Valuation – A company’s net asset value is the emphasis of an asset-based approach to business valuation. Total liabilities are subtracted from total assets to arrive at the net asset value. There is some space for interpretation when determining which of the company’s assets and liabilities to include in the assessment and how to measure their worth. Financial executives have a significant duty in determining and keeping awareness of a company’s value.
- Income Approach Valuation – The income approach is a method that is used to determine the value of the assets based upon the income generated by the investors. It is a reality-based estate assessment method. It’s calculated by dividing the rent collected net operating income (NOI) by the capitalization rate. The income approach is one of three prevalent approaches to assessing real estate and is primarily utilized for income-producing properties.
Things to Consider Before Valuing the Financial Instruments
The following are the suggestive criteria to consider when determining the suitable method or combination of methodologies for the valuation of financial instruments:
- The instrument’s valuation base and terms and conditions – The nature of the instrument and the terms and conditions that it embodies must be taken into account when choosing an appropriate valuation technique. The terms and circumstances of the instrument play a vital effect in setting the market comparable.
- Purpose of Valuation – A determining factor is an objective for which valuation is being employed. In general, when it comes to business combination transactions, the valuation methodology that considers more observable inputs takes precedence over other alternatives.
- The entity’s control framework and input data sets – A determining factor is an objective for which valuation is being employed. In general, when it comes to business combination transactions, the valuation methodology that considers more observable inputs takes precedence over other alternatives.
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Prices and other relevant information created by market transactions involving identical or comparable assets are used to assess the worth of the financial instrument in an active market. If you are looking for financial instrument valuation, we have the best team of experts who help you to get a financial instrument valuation. Eqvista helps in doing the most effective valuation and if you are a business owner looking for one. Get in touch with us by filling up a sign-up form and getting free consultation today.