# Lease Accounting / FX Embedded Derivatives: How to Value Floor / Cap Optionality Features

Suppose you have a lease agreement where the functional/domestic currency is RUB and the currency on which the lease is written USD. Let $S$ be the USD/RUB exchange rate (# of rubles per 1 dollar). The lessee pays $NS_{t}$ RUB at each time $t$ the lease payment is due, where $N$ is some fixed amounts in USD. This exposure to $S_{t}$ creates an embedded derivative which must be "bifurcated" and valued separately on the lessee's balance sheet.

The derivative can be viewed as a short position on a USD/RUB forward contract (sell USD, buy RUB), where the strike is determined by the forward rate curve at inception of the lease agreement. This is straight-forward to value periodically on future dates.

Now suppose this agreement also has a floor $\underline{S}$ and a cap $\overline{S}$.

The cap is an asset to the lessee, since it limits the downside associated with a weakening RUB, while the floor is a liability since it limits the upside gain associated with a strengthening RUB. In other words, in terms of embedded derivatives, the cap is a long position in a USD/RUB call option struck at $\overline{S}$ and the floor is a short position in a USD/RUB put option struck at $\underline{S}.$

My question is this: Should we value this embedded derivative as the sum of the values of the cap + floor + FX forward? This seems logical, and what you would do if this arrangement was an actual OTC derivative contract. However, being that this is an embedded derivative, is it appropriate to value the optionality features like they were options? Something keeps nagging at me as if including the time-value of the optionality features is inappropriate - that only the intrinsic value is what is important in this case.

Update

Let $L$ be the lease agreement, $D$ the embedded derivative, and $B$ the bifurcated lease payoffs at time $t$, $K$ the strike for the time $t$ cash flow as determined from the forward curve at time $t=0$ (inception).

Then $L=D+B$ and we assume the USD notional is $N=1$ for convenience.

The terms of the lease agreement imply $$L=\left\{\begin{array}{ll}-\overline{S},&S_{t}>\overline{S}\\-S_{t},&\underline{S}\leq S_{t}\leq\overline{S}\\-\underline{S},&S_{t}<\underline{S}.\end{array}\right.$$

To make $B$ riskless, we simply put $$B:=-K.$$ Then, $$D=L-B=\left\{\begin{array}{ll}K-\overline{S},&S_{t}>\overline{S}\\K-S_{t},&\underline{S}\leq S_{t}\leq\overline{S}\\K-\underline{S},&S_{t}<\underline{S}.\end{array}\right.$$

But one verifies that then $$D=\max(S_{t}-\overline{S},0)-\max(\underline{S}-S_{t},0)-(S_{t}-K)=C-P-F$$ where $C$ is an $\overline{S}$ struck USD/RUB call, $P$ is an $\underline{S}$ struck USD/RUB put, and $F$ is a $K$ struck USD/RUB.

I think this analysis answers my question in the affirmative.

• 1. What GAAP are you talking about? IFRS or Russian?
– GWD
Mar 15, 2015 at 10:54

• I'm a little bit confused. If you're correct, then it should be a bear spread (the position loses money if USD/RUB goes up - so the "cap" is really a floor and the "floor" is really a cap). In any event, if I plot the payoffs from the short forward, the long call (with $\overline{S}>\underline{S}$) and the short put (with $\underline{S}$), the net payoff looks like the correct payoff for the embedded derivative. Hence, its value at the time of the cash flow should be the value today, hence valuing it as a long call + short put + short forward. Mar 15, 2015 at 23:58
• I'm not quite sure what you mean by "doubling up." Once $S_{t}>\overline{S}$, the payoff is $K-\overline{S}$ (the sum of the call + forward payoff) - i.e. the call's value starts compensating for the forward's loss beyond beyond $S_{t}=\overline{S}$. Similar for the short put/short forward position. Mar 16, 2015 at 0:04
• Coming from the Put/Call parity side $+F = +C -P$ you are basically replicating the short Call ($-C$) position I am talking about via the relation $-C = -P -F$. Sorry about the "double up" error- that was a misunderstanding of your first explanation from my side. But based on your Update I hope I could make myself clearer now.