Risk Management Basics
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Embedded Derivatives | Examples | Accounting | IFRS – As the name suggests it is a hybrid security which has an embedded derivative component in a non-derivative instrument. Some financial instruments are known to combine a derivative and a non-derivative in a single contract. In this case the derivative part is known as embedded-derivative.
In this article, we take an indepth look at Embedded derivatives with real life examples –
- What are Embedded Derivatives?
- Uses of Embedded Derivatives
- Accounting for embedded derivatives
- Embedded Derivatives Accounting Examples
- Embedded derivatives which cannot be identified or measured?
- Real life examples of embedded derivatives
What are Embedded Derivatives?
Let us learn Embedded Derivatives with an example:
Let’s say there is an entity, XYZ Ltd., which issues bonds in the market. However, the payment of coupon and principal component of the bond is indexed with the price of Gold. In such a scenario the payment of 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 embedded derivative.
The non-derivative component here is also referred as host contract and the combined contract is hybrid in nature.
Uses of Embedded Derivatives
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 risk management practises of any organisation. Many organisation in the current working environment are paying production cost in one currency while they are earning revenue in another currency. In such a situation organisations are opening themselves up to currency rate fluctuation risk. To protect themselves from such currency risk they hedge the same using different derivative 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 discussion with 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 (type of embedded derivative instrument) is 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 allows financial world to create structured complex financial products. In most of this cases the risk component of one instrument is transferred to return component of the other. The global financial markets have introduced many such products in the market in last 20 to 30 years and this is the prime reason why understanding these products is very important.
Accounting for embedded derivatives
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, effort has been made in direction due to which embedded derivatives are accounted 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 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 process of bifurcation. The stock option portion which is an embedded derivative then needs to be accounted as 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 as per mentioned above.
However, it is very important to understand that not all embedded derivatives have to be bifurcated and accounted for separately. A call-option within a fixed-rate bond is a derivative which 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 purpose.
- As per International Financial Reporting Standards (IFRS), the embedded derivative needs to be separated from the host contract and needs to be accounted separately.
- This condition for accounting needs to be maintained unless the economic and risk characteristics of both host contract and embedded derivative are closely related.
Embedded Derivatives Accounting Examples
Embedded Derivatives Example 1:
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 price of gold). Hence in this case the embedded derivative needs to be separated from the host contract and needs to be accounted separately.
Embedded Derivatives Example 2:
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 share price of the company). Hence, in this case the embedded derivative need not be separated from the host contract and can be accounted together. This is because of the fact that both have the same economic and risk characteristics.
Embedded Derivatives Example 3
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 2% interest rate and the conversion details says 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:
Conversion option (at fair value) $500,000
Discount on Bond $500,000
What about the embedded derivatives which cannot be identified or measured?
The FASB has recognised 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 to be recognised at fair value and the changes in fair value to be recognised in current earnings. This is including both the host contract and the embedded derivative portion in the contract.
Real life examples of embedded derivatives
Let us now look at some of the situations in which 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 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
|Hybrid Instrument containing an embedded derivative||Identifying embedded derivative||Is the embedded derivative clearly and closely related to the host?||Bifurcation and separate accounting required for embedded derivative?|
|Floating rate bonds which has interest rate tied to interest index like LIBOR, prime rate, repo rate||There is no case of embedded derivative in this situation||N/A||N/A|
|Fixed rate bond with a fixed interest rate||There is no case of embedded derivative in this situation||N/A||N/A|
|Callable debt instrument: In this kind of debt instrument the issuer has the option to prepay.||Call option for issuer to prepay debt instrument||Yes: Interest rate and call options are closely related.||No|
|Convertible debt investment: Investor has the option to convert the debt instrument into the equity of the issuer at an established conversion rate||Call option on issuer’s stock||No the equity based underlying is not closely related to debt instrument. However there can be an exception when the equity shares of the entity does not trade in the market and hence no cash settlement can take place.||Yes. The embedded derivative will be recorded at the fair value and changes will be recorded in earnings.|
|Equity indexed Note: In such an instrument the return or principal and interest of the debt the debt instrument is linked with an equity Index.||A forward exchange contract with an option tied with the specified equity index.||No the forward or option contract and the debt instrument are not closely related.||Yes. The embedded derivative will be recorded at the fair value and changes will be recorded in earnings.|
|Credit Sensitive bond: the bond whose coupon rate that resets based on the changes in the credit rating of the issuer||Conditional exchange option contract that entitles investor to a higher rate of interest if the credit rating of the issuer declines.||Yes the creditworthiness of the debtor is clearly and closely related to the debt instrument.||No|
All the above mentioned situations in the table are real life financial instruments.
It is very important to understand that understanding the embedded derivative product is one step, however accounting for it in your books is another complex steps. The place has consistently evolved as the financial world keep on coming out with financial products which plays 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 banks balance sheet, it would be interesting to see how they are managing the interest rate risk and the kind of embedded derivative transactions which they are getting into.