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, p. 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, p. 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, p. 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, p. 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, p. 1042).

Examples of Embedded derivative

  • Embedded derivatives are commonly found in loan contracts, such as mortgage-backed securities and credit default swaps. In these cases, the embedded derivative is typically used to modify the interest rate or principal payments of the loan in order to hedge against potential changes in the value of the loan.
  • Embedded derivatives can also be found in insurance contracts, such as the payment of an indemnity or the pricing of a policy premium. In these cases, the embedded derivative is typically used to modify the terms of the policy in order to better reflect the underlying risks.
  • Embedded derivatives are also commonly used in commodity contracts, such as futures contracts and forward contracts. In these cases, the embedded derivative is used to modify the terms of the contract in order to better reflect the underlying market conditions.
  • Embedded derivatives are also commonly found in equity instruments, such as options and warrants. In these cases, the embedded derivative is used to modify the terms of the instrument in order to provide the holder with additional protection against potential changes in the value of the underlying security.

Advantages of Embedded derivative

The use of embedded derivatives has several advantages, such as:

  • Increased flexibility in the design of financial instruments: Embedded derivatives allow for the combination of two different instruments into one hybrid instrument, allowing for more flexibility and customization of the resulting financial instrument.
  • Increased efficiency in financial markets: Embedded derivatives allow for the creation of instruments whose returns are linked to multiple underlying assets, which makes it easier to diversify risk and create more efficient markets.
  • Reduced counterparty risk: Embedded derivatives allow for the transfer of risk from one party to another without having to enter into a direct contract. This reduces counterparty risk and makes it easier to manage financial instruments.
  • Improved transparency in financial markets: Embedded derivatives allow for greater disclosure of the underlying assets, making it easier to understand the risk associated with the instrument.
  • Lower costs: Embedded derivatives allow for the creation of instruments with lower transaction costs. This makes it easier for investors to access the markets and can lead to more efficient pricing.

Limitations of Embedded derivative

Embedded derivatives have several limitations which should be taken into consideration when deciding to use them. These include:

  • Valuation complexity - Valuing embedded derivatives can be a complex process that requires specialized knowledge, particularly when the valuation requires the use of models and inputs that are not readily available or transparent.
  • Increased risk - Embedded derivatives can increase the risk of the instrument, as their performance is linked to the underlying asset or the market.
  • Lack of liquidity - Embedded derivatives are not as liquid as stand-alone derivatives, as they are often customized and may not be traded on an exchange.
  • Regulatory risk - Embedded derivatives may be subject to greater regulatory scrutiny, as they can be used to circumvent regulatory or accounting requirements.
  • Counterparty risk - Embedded derivatives can also expose the issuer to counterparty risk, as they may require counterparties to perform in order to settle the instrument.

Other approaches related to Embedded derivative

To illustrate the other approaches related to embedded derivative, the following list should be considered:

  • Fair Value Method - this approach implies that embedded derivative is separated from the host contract and accounted for at fair value. Changes in the fair value are recognised in profit or loss (Beyersdorff M. i in. 2013).
  • The Cash Flow Hedge Method - it is a method used to hedge cash flows of a foreign currency denominated instrument. It is applied when the risk of a contract is hedged using another instrument or when a net present value of a contract is expected to change due to foreign currency (IAS 39.10).
  • The Contractual Method - this method requires that the future cash flows of the contract are allocated to the host and the embedded derivative, based on the relative fair values of the two components (Chaudhry A. i in. 2015).

In summary, embedded derivative is a component of a hybrid instrument that is accounted for using fair value, cash flow hedge and contractual methods.


Embedded derivative — recommended articles
Swap Ratio — Fair value hedge — Basket Option — Asset swap — Interest Rate Collar — Collateral management — Credit instrument — Asset-swap spread — Currency certificate

References

Author: Urszula Bochenek

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