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What is residual value risk?

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When a finance lease is terminated and the residual value is unguaranteed, the lessor will repossess the asset and may be unable to re-lease or sell it at its residual value.  Residual value risk is the possibility that a lease asset can only be resold or re-leased at a price below the asset’s residual value.  Residual value risk equals the difference in the residual value of a leased asset set a lease inception and the lower salvage value realized upon it disposal or re-lease at the end of the lease term and is borne either by the lessor – if unguaranteed – or the lessee – if guaranteed – in accordance with the contractual terms.

Because the economics of a lease rely on the leased asset’s residual value in addition to the other sources of repayment, leasing generally exposes lessors to more residual value risk than other types of lending.  Leasing exposes lessors to losses from unexpected price changes in the leased asset over the lease term or when it is held as an off-lease asset.  Whereas open-end leases transfer residual value risk to the lessees, closed-end leases expose lessors to this risk.

TRAC Lease
This illustrates the cost of leased equipment under a TRAC lease, the asset's carrying amount (book value) and its salvage value over the lease term and the potential gain or loss of the lessee and the lessor when the asset's salvage value is greater or less than its residual value, respectively, at the end of the lease term.

If leased equipment suffers a loss, the lessee may be required to pay the loss value or similar amount in order for the lessor to recover its investment and the anticipated return on investment and indemnity for any economic harm suffered.  Alternatively, the lease may permit the lessee to replace the damaged or lost equipment.

Vendors often provide buyback guarantees to repurchase their leased equipment from lessors upon lease termination, which reduces the lessor’s resale and residual value risks but exposes the lessors to vendor riskVendor risk is where a vendor can potentially negatively affect a lease transaction due to its inability to perform as required and failure to fulfill its obligations toward the lessor, such as the good delivery of equipment and its proper maintenance or failure to buy back the equipment when it goes off-lease.

Elements of Vendor Risk Management Process
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