Embedded derivative

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Embedded derivative
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Embedded derivative is "a component of a hybrid instrument that also includes a non-derivative host contract with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative" (Chaudhry A. i in. 2015, s. 690). By implying, some or all of the cash flows that are otherwise required by the contract, are modified in accordance with the underlying system [IAS 39.10] (Beyersdorff M. i in. 2013).

An embedded derivative causes that some (or all) of the cash flows that otherwise would be needed by the contract to be moderated in accordance with, for example: "a specific interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index or other variable, provided in the case of a nonfinancial variable that the variable is not specific to a party to the contract" (Chaudhry A. i in. 2015, s. 690). However, a derivative attached to a financial document, but at the same time being contractually transferable independent, is a separate financial instrument - not an embedded derivative (Chaudhry A. i in. 2015, s. 690).

Requirements for embedded derivatives

The embedded derivative should be separated from the host contract and also cover all selected conditions stated below (paragraphs 12-16 and 60-61 of SFAS No. 133 and paragraphs 8 (a) and (b) and 9 (a) - (c) SFAS No. 149) (Jarnagin D. B. 2008, s. 1042):

  1. Changes in the fair value of a hybrid instrument or contract are not disclosed in the composition in accordance with the statements of accounting principles, which normally comply with the instrument - it means that if the instrument was accounted for another principle than SFAS No. 133, the hybrid instrument or contract would not be measured again at fair value in each accounting period with some change in the value stated in the income statements.
  2. The embedded derivative would be included as a derivative in accordance with SFAS No. 133, if it was a separate instrument or contract with the same regulations.
  3. The risk and economic attributes of the embedded derivative (and also host contract) cannot be closely and clearly connected - that requires clarifications and this is the most difficult condition in practical use. To illustrate this, suppose that an entity has leased equipment (with future payments) connected to an interest rate that is volatile.

The embedded derivative is clearly connected with the lease contract (Jarnagin D. B. 2008, s. 1042).


Author: Urszula Bochenek