Embedded Derivatives

You might have come across several non-financial agreements. These agreements between two parties usually do not involve financial instruments. You can find embedded derivatives within such contracts. These derivatives are found within host contracts but act similar to traditional derivatives. Continue reading to understand what embedded derivatives are in this blog.

What are Embedded Derivatives?

Embedded derivatives are financial instruments usually found within non-financial contracts. The non-financial or host contract is a large contract that contains the embedded derivative. These derivatives are not traded individually in the market, as they are found within host contracts. Host contracts can be a range of agreements between two parties, from lease agreements to loan documents. The embedded derivative could be anything, from futures & options to swaps. They are often challenging for accountants and bookkeepers. In some cases, they consider an embedded derivative as a separate entity in accounting books, as it has its own value.

Embedded Derivatives Example

Let us discuss an embedded derivatives example for a clear understanding. Let us say a corporate entity issues an equity-linked note for investors. An equity-linked note is a debt instrument that promises the principal repayment. The final payment or the principal repayment is based on the performance of a particular stock. The stock is included in the equity-linked note as an embedded derivative. In this case, the equity-linked note is the host contract.

Additionally Read: What is Derivative?

An equity-linked note might not offer regular interest payments. However, it will offer the principal repayment, along with some additional amount. The additional amount will depend on the performance of the underlying stock, which acts as an embedded derivative. For instance, the equity-linked note can offer a return equal to the percentage increase in the stock’s worth in the market. The return might be capped at 60% or any other value by the issuer. All these terms are mentioned within the host contract, which is the equity-linked note.

Uses of Embedded Derivatives

Embedded derivatives are used for a variety of host or non-financial contracts. One can find them within a range of host contracts. These host contracts include bonds, convertible bonds, lease agreements, insurance contracts, commodity contracts, equity-linked notes, foreign currency-denominated debt, structured notes, or supply/purchase agreements. You will find options, futures, and other derivatives embedded within these host contracts.

They are found within tailored financial products or contracts. These contracts are designed to suit the preferences of both parties. Also, these tailored contracts are not traded publicly for everyone. They are mutual agreements between two interested parties. Many investors or entities depend on these derivatives to gain leverage. Since they have the power to amplify returns, investors can bet on the underlying asset. However, these derivatives can also amplify losses in some cases.

Accounting of Embedded Derivatives

Now that you understand the embedded derivatives meaning, let us discuss the accounting part. Accounting or valuation of these derivatives adds an extra step for concerned individuals. Accountants are required to treat them as individual entities in books, even though they are found within bigger non-financial contracts. Accounting standards have been set regarding embedded derivatives in different jurisdictions.

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Accounting standards for such derivatives were mandatory. Individuals who drafted these standards feared that entities might abuse these derivatives. They might hide derivatives within non-financial contracts without the need to report them. One might hide the earnings from these derivatives, thus indulging in tax evasion. Luckily, all these things cannot happen due to strict accounting standards for embedded derivatives now.

Embedded derivatives are recorded in accounting books, similar to derivatives instruments. The embedded derivative in a host contract must be separated through the process of bifurcation. However, it adds an extra step for accountants and bookkeepers.

Embedded Derivatives Accounting – Bifurcation

As discussed above, bifurcation is the process of separating the embedded derivative from the host contract. The separation is required for reporting these derivatives in the accounting book. Let us take an example to understand the bifurcation process for accounting for these derivatives.

Let us say a financial contract contains a stock option, which acts as an embedded derivative. The stock option will be separated through bifurcation and accounted for at fair value. On the other hand, the financial contract will be treated individually, considering there is no derivative included. Both instruments (host contract and embedded derivative) are treated individually by accountants.

It is crucial to note that some of these derivatives do not require bifurcation. Call options within fixed-rate bonds, indexed debts, and non-compensatory interest rate floors are some that do not require bifurcation for accounting.

Differences Between Embedded Derivatives and Derivatives

One might confuse embedded derivatives with regular derivatives. Here are the dissimilarities between both types of derivatives:

Embedded Derivatives Derivatives

These are derivatives included or hidden within bigger financial contracts.

These are standalone financial instruments that derive their value from an underlying asset.

Since they are included within bigger contracts, they cannot be traded individually.

Since derivatives are standalone financial instruments, they can be traded on stock exchanges.

An embedded contract can influence the cash flows or terms of the host contract. For instance, the payment for a debt contract might depend on the performance of these derivatives.

Derivatives are standalone instruments, and they influence their own value.

They can only be found within non-financial contracts. These contracts are not found on public stock exchanges. Interested parties can create such contracts based on their preferences.

Derivatives are actively traded in an organised manner on stock exchanges.

Embedded derivatives are found within lease agreements, insurance contracts, structured notes, and other host contracts.

Derivatives are individual instruments. They can be futures, options, or swaps.

Embedded derivatives, found within financial instruments, fluctuate based on underlying asset performance. Simplify trading them by accessing platforms offering free demat account opening.

Conclusion

Embedded derivatives are found within insurance contracts, structured notes, lease agreements, and other contracts. These are different from regular derivatives traded individually on stock exchanges. The accounting process for these derivatives is also a little different.



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