What Is An Embedded Derivative

What is an Embedded Derivative?

An embedded derivative constitutes a part of a financial instrument that also includes a non-derivative host contract. When a hidden derivative contract exists in a non-derivative host that does not go through the profit and loss account is called an embedded derivative. In an embedded contract, a part of the cash flows depends on an underlying asset while it also has a fixed part.

An embedded derivative requires a part of the contract's cash flows to be modified according to changes in another variable. These variables may include interest rate, commodity price, credit ratings, or foreign exchange rates. However, a derivative that is contractually transferable separately from the contract is not an embedded derivative.

What are the uses of Embedded Derivatives?

Embedded derivatives are a part of various types of contracts, such as leases and insurance contracts. Sometimes, preferred stocks and convertible bonds also come with these derivatives. Therefore, there are several practical uses of embedded derivatives.

The embedded derivatives are most prominently common in risk management for companies. Many companies that have foreign currency transactions may face the risk of currency rate fluctuations. Therefore, these companies may hedge those risks using various types of derivatives, such as interest rate swaps.

However, companies may also embed the risk in contracts with clients. In these types of contracts, companies can link their revenues to their production costs directly. Therefore, the specialized contract takes the form of an embedded derivative.

Similarly, embedded derivatives also allow financial institutions to create structured complex financial products. In some of these financial products, they transfer the risk component in one instrument to another instrument's return component. There are various products that use embedded derivatives, and their number has increased over time.

What is the accounting treatment of Embedded Derivatives?

The accounting treatment for embedded derivatives requires the accountant to separate the stock option component first. The separation occurs through the process of bifurcation. After separating the embedded derivative portion, the accounting treatment is similar to any other derivative.

For the host contract, the accountant should carry out the treatment as per the related standard. So, it should assume that it has no derivative attached. Therefore, both instruments within the contract must get accounted for separately.

However, there may be some exemptions from this accounting treatment in some cases. The bifurcation treatment is not necessary for every embedded derivative. For example, for a call-option within a fixed-rate bond, the bifurcation process is not a requirement.

What are the various types of Embedded Options?

There are two primary categorizations of embedded options. Firstly, some options provide rights to the issuers of a financial instrument. On the other hand, some options provide rights to their holders. The first type of options that give issuers the rights includes a call and a capped floating rate provision.

On the other hand, options that grant holders the right to the security may also come with various options. These contain put, convertible, exchangeable extendable, or floored floating rate provisions. Each of these varies from each other.

Conclusion

Embedded derivatives come with several types of contracts, which come with a non-derivative host contract.  There are several uses of these derivatives in the practical. For the accounting treatment of embedded derivatives, it is necessary to separate the stock component first.

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