A Reduced-Form Model for Lease Contract Valuation with Embedded Options
62 Pages Posted: 21 Oct 2011 Last revised: 20 Dec 2017
Date Written: December 19, 2017
This paper derives an integrated reduced-form model to calculate the values of adjustable-rate leases with embedded cancellation, purchase, and default options. We also provide numerical examples showing that for a 30-year lease contract, the lessor offers a 15% discount in the initial rent, but charges an additional 33.14% for the cancellation, 12.16% for the purchase, and 20.73% for default options in comparison to the contract without any embedded options. This result suggests that ignoring embedded options in valuing a lease contract leads to significant pricing errors. Thus, we provide a flexible and implementable framework to value complex lease contracts and enhance the efficiency of real-estate lease portfolio management.
Keywords: Lease Contracts, Embedded Options, Default Risk, Adjustable Rate
JEL Classification: G12, G13
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