What Is an Embedded Derivative?

An embedded derivative is a provision in a contract that modifies the cash flow of a contract by making it dependent on some underlying measurement. Like traditional derivatives, embedded derivatives can be based on a variety of instruments, from common stock to exchange rates and interest rates. Combining derivatives with traditional contracts, or embedding derivatives, changes the way that risk is distributed among the parties to the contracts.

A derivative is any financial instrument whose value depends on an underlying asset, price or index. An embedded derivative is the same as a traditional derivative; its placement, however, is different. Traditional derivatives stand alone and are traded independently. Embedded derivatives are incorporated into a contract, called the host contract. Together, the host contract and the embedded derivative form an entity known as a hybrid instrument.

The embedded derivative modifies the host contract by changing the cash flow that would otherwise be promised by the contract. For example, when you take out a loan, you agree to repay the funds plus interest. When you enter this contract, the lender worries that interest rates will go up, but your rate will be locked in at a lower rate. He can modify the loan agreement by embedding a derivative, so that interest payments depend on another measurement. They could, for example, be adjusted according to a benchmark interest rate or a stock index.

Embedded derivatives are found in many types of contracts. They are frequently used in leases and insurance contracts. Preferred stock and convertible bonds, or bonds which can be exchanged for stock, also host embedded derivatives. The specific accounting principles for embedded derivatives are complicated, but the basic concepts are that the embedded derivative must be accounted at fair value and that it should only be accounted separately from the host contract if it could stand alone as a traditional derivative.

A contract with an embedded derivative can substitute for another type of risk management; for example, some companies conduct business in more than one currency. By paying production costs in one currency and selling the product in another, they bear the risk of adverse fluctuations in the interest rate. Often, these companies participate in foreign exchange futures trading to hedge the risk they face. Another option is to embed the foreign exchange future into the sales contract. This differs from the original strategy in that the buyer now faces the risk, where a third party traded stand-alone futures with the corporation.

This example illustrates the primary function of embedded derivatives: to transfer risk. They shift the terms of a traditional contract so that the party that would have been subjected to the risk associated with, for example, interest rates or exchange rates, is shielded, while the other party is exposed. Embedded derivatives are used to convince investors to participate in otherwise unattractive contracts by making the contracts less risky.

For an example of an embedded derivative, consider the following. The company LMN Ltd. issues bonds to the market. However, both the principal component associated with the bond and the payment of coupon are indexed according to the price of silver. Within this situation, the price of silver and its performance in the market will directly correspond to either an increase or decrease with the cost of the coupon. The bond issued by LMN Ltd. is the non-derivative or debt instrument, while the payments are linked to another instrument. Silver becomes the derivative component which is also the embedded component.

Many organizations use embedded derivatives for risk management practices. Commonly, production costs are incurred under one currency while revenue streams occur in a different currency. The organizations do face a currency rate fluctuation risk but establish protection against these risks through types of derivatives contracts. These could include taking positions at a future time or interest rate swaps. However, companies can also embed the risk in a sales contract. Within these arrangements, there will be a direct link between the production expenses for the company and the resulting revenue.

Interest rate derivatives are a type of embedded derivative instrument, and companies will use these to help mitigate interest rate risk. While not as prevalent as in years past, thanks to the institution of complex accounting measures, banks will still use variable-rate funding structures with embedded derivatives. Examples of these include floors, corridors or interest rate caps. The instruments are closely related to the concept of rates paid on the borrowing, which makes them exempt from the guidelines of FASB 133 concerning accounting and reporting standards.

Even with the ASC 815 clearly defining an embedded derivative, not all contract participants or business professionals understand how to identify these instruments. First and foremost, these derivatives exist within a hybrid instrument, where there is both a host contract and embedded derivative. Hybrid instruments present a challenge, as it needs to be determined whether or not the instrument remains one instrument for the purposes of accounting and valuation or it should bifurcated. This means that the host contract and the embedded derivatives are recorded separately when applying the Generally Accepted Accounting Principles.

If it’s a case where the embedded derivative must be released from the host contract, there will be a separate recording for the embedded derivative on the balance sheet according to fair value. Any changes to the fair value will need to be immediately recorded through earnings. Normal GAAP accounting would take place with the host instrument.

There are three easy steps to determine embedded derivatives. Broken down, they are easier to understand.

The first in identification is to identify the embedded derivative and host of the hybrid instrument. You can identify the host contract through one of the following classifications: lease contracts, equity instruments, or loans, insurance contracts and other debt instruments. The next analysis must determine if the embedded feature meets the characteristic guidelines of ASC 815. These include:

You must determine if the hybrid instrument should be separate. This can be done by asking three questions.

When identifying the value of an embedded derivative, it’s important to look at both the host and the derivative. If bifurcation is required for the hybrid instrument (based on answering the questions of identification), the embedded derivative is recorded through a fair market value However, the ASC 815 requires valuation to use the“with and without” analysis. Changes that occur in fair value are recorded as earnings. Fair market considerations are viewed according to the context of additional or implied yield with acknowledgment for baseline cash flows. These could put or call features, PIK interest or attached warrants.

Embedded derivatives are required to be valued when issued, and revaluation must take place in all subsequent quarters where that are changes in non-cash reported values. Continual valuation provides insight on constant price or yield and the increase or decrease in risk for a company.