Embedded Derivatives

Where a derivative contract is hidden in a non derivative host contract (either debt or equity component) which doesn’t pass through profit and loss account known as the embedded derivatives and hence in an embedded derivative contract, a part of the cash flow depends on an underlying asset which another part of cash flow is fixed.

The place has consistently evolved as the financial world keeps on coming out with financial products that play around with the regulation in some way or the other. Investors should understand the financial implications of the embedded derivatives and should clearly look at the underlying and the factors which impact it. If an investor is assessing any bank balance sheet, it would be interesting to see how they are managing the interest rate risk and the kind of embedded derivative transactions that they are getting into.

• Embedded derivatives are financial instruments included in non-derivative contracts, such as loan agreements or insurance policies.
• These derivatives are embedded within the host contract and cannot be separated and traded independently.
• The value of embedded derivatives is derived from an underlying variable, such as interest rates, foreign exchange rates, or commodity prices.
• Accounting standards require companies to recognize and measure embedded derivatives separately from the host contract under certain conditions.

Embedded derivatives are a type of financial instrument, which is contained within a bigger non-financial contract. They are known as embedded dure to the fact that they are not traded on a standalone basis, instead integrated into a bigger agreement.

In the process, there is a host contract, that is non-financial in nature, containing the embedded derivative. The host contract can be anything ranging from a purchase or loan agreement to a lease agreement. These derivatives may be in the form of options, forwards or swaps. In case of options, which is embedded within the host contract, gives the holder of the option the right but no obligation to purchase or sell an underlying asset at a particular price and time period.

In case the derivative is a forward or a swap, the derivative within the host contract will specify that there will be an exchange of cash flows or assets in the future and the process will be done based on some predetermined terms and conditions.

This kind of contract can sometimes become challenging and complex in nature when it comes to accounting or financial reporting. This is because they need to be separately accounting for from the host contract since the contract that is embedded in the host may sometime have a separate value which has to be independently measured and it may affect or change the value of cash flows of the total contract.

It is worth keeping in mind that the treatment of the embedded derivatives can be quite complicated and depends on the contract details and specifications. Valuation of embedded derivatives also depends on the accounting standards applicable. Organizations often seek professional help in case of handling such processes.

Let us learn Embedded Derivatives with an example:

Example #1

Let’s say there is an entity, XYZ Ltd., which issues bonds in the market. However, the payment of the coupon and principal component of the bond is indexed with the price of Gold. In such a scenario, the cost of the coupon will increase or decrease in direct correlation with the price of Gold in the market. In this example, the bond issued by XYZ

In this example, the bond issued by XYZ Ltd. is the debt instrument (Non-derivative), while the payments are linked with another instrument, which in this case, is Gold (Derivative component). This derivative component is known as an embedded derivative.

The non-derivative component here is also referred to as a host contract, and the combined contract is hybrid in nature.

Example#2

Let’s say XYZ Ltd issues bonds in the market where the payment of coupon and principal is indexed with the price of Gold. In this case, we can see that the host contract does not have economic and risk characteristics associated with embedded derivatives (which is, in this case, the price of Gold). Hence, in this case, the embedded derivative needs to be separated from the host contract and needs to be accounted for separately.

Example #3

Let’s say the same company, XYZ Ltd, issues bonds in the market where the payment of coupon and principal is indexed with the share price of the company. In this case, we can see that the host contract has economic and risk characteristics associated with embedded derivatives (which is, in this case, the share price of the company). Hence, in this case, the embedded derivative need not be separated from the host contract and can be accounted for together. This is because of the fact that both have the same economic and risk characteristics.

Example #4

Let us learn the concept explained above numerically by means of another example. Let’s say that ABC corporation buys a $10,000,000 XYZ company convertible bond with a maturity period of 10 years. This convertible bond pays a 2% interest rate, and the conversion details say that the bond can be converted to 1,000,000 shares of XYZ Company common stock, which shares are publicly traded. Under the accounting norms, the company must determine the value of the conversion option, which is embedded in the debt instrument, and then there is a need for separate accounting of it as a derivative. To account for it as a derivative, the fair value estimation was done, which showed the fair value of the bond stood at $500,000. This is arrived at using some kind of option pricing model.

ABC Corporation would pass the following journal entry for proper accounting:

Bond $10,000,000

Conversion option (at fair value) $500,000

Cash $10,000,000

Discount on bond $500,000

Example #5

Let us now look at some of the situations in which the accounting world takes a call on what kind of accounting treatment needs to be done for the embedded derivative. The decisions made under this table are drawn from an understanding of accounting standard 815. Readers are advised to study the standard in details if they want to fully understand the implications of the accounting standards related to embedded derivatives

All the above-mentioned situations in the table are real-life financial

Embedded derivatives are used in many types of contracts. The most frequent use of the embedded derivative has been seen in leases and insurance contracts. It has also been seen that preferred stocks and convertible bonds also host embedded derivatives.

Usage In Risk Management

Embedded derivatives have been used in the risk management practices of any organization. Many organizations in the current working environment are paying production costs in one currency while they are earning revenue in another currency. In such a situation, organizations are opening themselves up to currency rate fluctuation risk. To protect themselves from such currency risk, they hedge the same using different types of derivatives contracts available such as interest rate swaps, taking positions in futures, and options. However, the same risk can be embedded in the sales contracts after a discussion with the client. Under such an arrangement, the revenue can directly be linked with the production cost incurred by the company. This is a classic example of risk management using embedded derivatives. This makes the whole contract less risky for the company and also helps in taking clientele into confidence.

For many years it has been seen that interest rate derivatives (a type of embedded derivative instrument) are a good way to manage interest rate risk. However, recently the trend has reduced because of the complex and complicated accounting measures in the space. The banks are now using variable-rate funding structures that have embedded derivatives. Examples of derivatives include interest rate caps, floors, and/or corridors. Currently, these kind of instruments are exempt from FASB 133 guidelines as they are closely related to the rates paid on the borrowing (this concept will be explained in details in the following sections)

Creating Structured Financial Products

The embedded derivative methods allow the financial world to create structured complex financial products. In most of these cases, the risk component of one instrument is transferred to the return component of the other. The global financial markets have introduced many such products in the market in the last 20 to 30 years, and this is the prime reason why understanding these products is very important.

It is very important to understand that understanding the embedded derivative product is one step. However, accounting and valuation of embedded derivatives for it the books is another complex step.

The requirement to account for certain embedded derivatives separately was originally intended to serve as an anti-abuse provision. The people who created these standards actually feared that entities might attempt to “embed” derivatives in contracts unaffected by the derivatives and hedging activities guidance so as to avoid its requirement to record the economics of derivative instruments in earnings. To provide consistency in accounting methods, the effort has been made in direction due to which embedded derivatives are accounted for in a similar manner compared to derivative instruments. For such a scenario, a derivative that is embedded into the host contract needs to be separated, and this process of separation is referred to as bifurcation. Let us understand this by an example.

Embedded Derivatives Accounting - Bifurcation

An investor in the convertible bond is required to separate the stock option component first by the process of bifurcation. The stock option portion, which is an embedded derivative, then needs to be accounted like any other derivative. This is done at the fair value level. However, for the host contract, accounting is done as per the GAAP standard, considering the fact that there is no derivative attached. Both the instruments are treated separately and accounted for, as mentioned above.

However, it is very important to understand in case of embedded derivatives accounting that not all embedded derivatives have to be bifurcated and accounted for separately. A call-option within a fixed-rate bond is a derivative that does not require bifurcation and separate accounting.

Criteria Or Situation Which Defines Bifurcation?

• There are certain ways in which an embedded derivative needs to be treated for accounting purposes.
• For the purpose of embedded derivatives accounting, as per the International Financial Reporting Standards (IFRS), the embedded derivative needs to be separated from the host contract and needs to be accounted for separately.
• This condition for accounting needs to be maintained unless the economic and risk characteristics of both the host contract and embedded derivative are closely related.

The FASB has recognized that there are many circumstances under which the embedded derivatives cannot be reliably identified or measured for separation with the host contract. In such a scenario, accounting standard 815 requires that the entire contract be recognized at fair value and the changes in fair value to be recognized in current earnings. This is including both the host contract and the embedded derivative portion in the contract.

The above are two types of financial instruments. However, both have some differences, which lies in their structure and nature of contracts. Let us study the basic differences between them.

• The former is a financial instrument that lies with a bigger non-financial contract, but the latter is a financial contract that is standalone and derives the value from some other instrument like an index, asset or a reference rate, which can be independently traded like any other contract.
• The former is not standalone, but integrated in the host contract due to which they cannot be bought or sold independently, whereas the latter is standalone in nature.
• The former has the capacity to modify the cash flows or the terms and conditions of the host contract, which is not the case with the latter.
• Derivatives are traded in organized exchanges or over the counter markets which is not the case with embedded ones.
• The former is typically found within insurance policies, convertible bonds, lease agreements etc, but the latter is commonly futures, swaps, option or forward contacts.
• Derivatives are widely used for speculation, hedging or management of risks, which may not be the case with the former.

Thus, it is necessary to know and understand the differences between them clearly so that each can be used effectively is areas where they add considerable value.

This article has been a guide to Embedded Derivatives and its meaning. We explain it with examples, accounting & differences with derivatives.

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