The historical cost principle and the fair value concept: The basic measures of the value of synthetic financial instruments

Abstract

The contemporary global financial market is characterized by the fact that most financial instruments can be replicated. The replication procedures involve the construction of a new financial instrument through combining other financial instruments, so that the effect of the combination is identical to the properties of the existing instrument. New financial instruments, referred to as synthetic instruments, are constructed on the basis of both primary and derivative instruments. A synthetic instrument is a financial structure based on an appropriate combination of primary and derivative instruments—their substitutes. It provides the possibility of constructing any type of a financial instrument. The paper presents a concept for designing synthetic instruments on the basis of the call/ put parity. The call/ put parity can be a basis for designing a synthetic share, a call option and a put option, and a risk-free investment. The concepts were used to develop two strategies (strangle and straddle) based on synthetic instruments. The balance sheet valuation of strangle and straddle spread strategies was based on a mixed valuation model, making use of two basic measures of valuation—historical costs and fair value.