Embedded value

Abstract: The recent financial crisis has raised challenges to market-consistent valuation, both in its implementation and application. These include both commercial and technical challenges. The whole concept of mark-to-market accounting has been questioned in some quarters.There have been commercial challenges in deciding how to assess business strategies given recent volatile market-consistent results, including the implications for ALM and new business pricing. Industry-wide, macroeconomic concerns have been raised regarding procyclicality.This paper recognises these commercial challenges and highlights how a combination of different forms of management information covering both market-consistent and other measures can help in making decisions. This paper sets out some possible approaches to mitigate procyclicality.There have been technical challenges in:– assessing how to value instruments in markets which are or have become illiquid– selecting an appropriate ‘risk-free’ or reference rate– deciding whether and how to make additional allowance for the liquidity premium or own credit risk– the calibration of stochastic models used to value embedded financial options and guarantees– assessing an appropriate allowance for non-hedgeable risk.This paper discusses these technical challenges. The paper proposes a way forward in some areas, taking into account the recent dislocation of the financial markets and drawing on recent Solvency II, IASB, FASB and MCEV developments.

Abstract: With Value-Based ALM the financial policy is not only evaluated in terms of the uncertain future financial position and balance sheet, but also in terms of the exposure of the beneficiaries to the total risk embedded in the pension deal. Traditionally, ALM studies do not explicitly reveal which stakeholders bear the risks in the pension deal when the investment strategy changes or in case of pension redesign. Value-based ALM does. This chapter shows how to identify contingent claims and embedded options on the balance sheet of collective public schemes. We develop an econometric model which can be used for classic ALM and the consistent pricing of embedded options. We illustrate the framework in the context of pension redesign and in the context of asset management and demonstrate how the embedded options reveal risk transfers between employers and beneficiaries. We demonstrate how a switch from a calendar rebalancing to a fixed strategic asset allocation towards a more risk-driven dynamic asset allocation can increase the participant share in total risk, while the employer share in risk decreases substantially. Classic ALM optimizes the policy, while Value-Based ALM can be used to ensure that this takes place on fair economic terms between stakeholders.

Abstract: Purpose – This paper seeks to consider a significant market misconception and related errors commonly made by valuers, financial decision makers, and other users of valuation services. Its purpose is to focus on the importance of relating the explicit requirements of market value and fair value definitions to the evidence required for a supportable opinion of either.Design/methodology/approach – The paper provides conceptual foundations for the terms “market value” and “fair value” and reviews their meanings and applications in a historical context. Business cycles and the recent recession are used as foundations for illustrating how prices, such as for real estate, vary with cycles, but are not always directly indicative of either market value or fair value. The latter term has a long history, but has undergone recent definition and revision by the US Financial Accounting Standards Board (FASB) that are shown to closely align fair value with market value. A current controversy over the use of transaction...

Abstract: This short paper studies the Economic Profit, a different label for the Economic Value Added, EVA. Copeland et al. (1995) show that the present value of the free cash flow and the present value of EVA (Market Value Added MVA) are not the same, unless the present value of future EVA (they call it economic profit) be added to the initial capital invested. This present value includes, in both of them, the continuing value, which is the present value of the perpetuity for the cash flow and for the economic profit. For both of them, they end up with the Entity Value and the Equity Value. They present an extensive example and it will be analyzed in this paper. In that example they show that both, Entity and Equity Value are the same when calculated through the free cash flow or the economic profit. In this paper that assertion is examined in detail. It will be shown with the same example presented by them, that it holds true only under very restrictive assumptions. This is, when WACC assumes a given value.