Derivatives

When this practice applies

Derivatives valuation is demanded by financial institutions, fund managers, M&A counsel, and listed companies. In all cases, the central challenge is to demonstrate that the applied model is defensible given the payoff and the market data available.

• Earn-outs and contingent consideration in M&A transactions, measured at fair value upon initial recognition under CPC 15 / IFRS 3 and remeasured at each balance-sheet date.
• Options and warrants issued by the company or received as consideration in corporate transactions.
• Fair value measurement of balance-sheet derivatives: NDFs, swaps, interest-rate options, in institutions and corporates with active hedge accounting.
• Stock options and share-based payments under CPC 10 / IFRS 2, with grant-date fair value modeling.
• Embedded optionality in commercial contracts: purchase, sale, early termination, renewal options, when accounting separation is required.
• Convertibles and hybrid instruments: convertible debentures, convertible notes, SAFEs, with equity option component separated from the debt component.
• Disputes and arbitration involving clauses with conditional payment or discretionary exercise.

Applied models

Model choice is determined by payoff structure: not methodological preference. Each family solves a specific set of problems, and applying the wrong model is a technical flaw before any consideration of inputs.

Technical procedure

The procedure below is applied in full to material derivatives. For plain-vanilla derivatives with active market (Level 1 / Level 2), the procedure simplifies to direct mark-to-market or mark-to-model with observable inputs.

1. Payoff decomposition

   Full contractual analysis to identify all embedded optionality, exercise triggers, cap clauses, floor, barriers, knock-in/knock-out, and path-dependence of the underlying.

2. Accounting classification

   Determination of classification under CPC 48 / IFRS 9: fair value through P&L (FVTPL), fair value through OCI (FVTOCI), or other applicable category, with explicit treatment of embedded derivatives requiring separation from the host contract.

3. Model selection

   Justified choice of valuation model according to payoff structure. Simpler models are preferred when they produce equivalent results: Occam applied to the quantitative.

4. Market input calibration

   Construction of interest rate curves (zero rate by currency, with bootstrapping from swaps and treasuries), implied volatility curves, historical and implied correlations, expected dividends, and carrying costs.

5. Underlying modeling

   For derivatives on assets without liquid market (private equity, real estate, intangibles), construction of expected distribution of the underlying via DCF, scenario simulation, or historical volatility of sector proxies.

6. Fair value calculation

   Execution of the selected model with calibrated inputs. For Monte Carlo, minimum of 100,000 simulations with convergence tests. For lattice, sufficient steps for 0.1% fair-value precision.

7. Sensitivity analysis (Greeks)

   Calculation of delta, gamma, vega, theta, and rho to measure sensitivity to critical inputs. In material derivatives, additional sensitization on model parameters (correlation, non-observable volatility).

8. Working papers, report, and technical defense

   Full documentation of model, inputs, sources, calibration, and code. Formal report under CPC 48 / IFRS 9 standard, with availability for auditor and fiduciary administrator review.

Areas of attention

Derivatives are the technical class where model and inputs are under simultaneous scrutiny. The points below concentrate the highest volume of review.

• Implied vs. historical volatility

  In derivatives on assets with liquid market, the CPC 46 / IFRS 13 hierarchy requires use of observable implied volatility. Substituting historical volatility without justification is immediate downgrade from Level 2 to Level 3.

• Volatility of underlying without market

  For options on private companies, volatility is built via sector proxies: listed comparables with leverage adjustment. Sample selection and adjustment are critical technical points.

• Correlation in multi-asset payoffs

  In earn-outs with multiple triggers or basket options, correlation among underlyings materially determines fair value. Simple historical correlation fails in stress periods: models with conditional correlation or copulas are required in engagements with multiple correlated triggers.

• Separation of embedded derivatives

  IFRS 9 requires separation of embedded derivatives not "closely related" to the host contract. Separability analysis is frequently underestimated, particularly in convertibles, supply contracts with price-revision clauses, and leases with options.

• Modeling earn-outs with cap and floor

  Earn-outs are typically call spreads on future operating metrics. Modeling them as expected value weighted by scenarios: without capturing the optionality: is a common technical error that undervalues the instrument.

• Counterparty credit risk treatment

  Material derivatives between private parties require DVA/CVA adjustment (Debit/Credit Valuation Adjustment) to reflect bilateral credit risk. Omitting the adjustment is a defensibility deficiency in critical engagements.

Applicable standards

Representative cases

Engagements involving valuation of derivatives and embedded optionality conducted by the CBG team.

Lead team