Residual Risk and the Valuation of Leases Under Uncertainty and Limited Information

Abstract

For a variety of tax, accounting, and economic reasons, leasing has become an enormously popular method of financing the acquisition of capital assets. The explosion in lease finance, however, has left many lessors exposed to substantial risks in the form of uncertainty over the residual values of the leased assets. Residual value risk has already led to substantial losses for a number of institutions in such well-established asset markets as automobiles. The extension of lease financing to more exotic assets thus presents a substantial challenge to the leasing industry's ability to identify and manage residual risks. This article presents a simulation framework for valuation of residual risks that is consistent with contemporary appraisal practice, but also explicitly recognizes the impact of uncertainty on residual values.