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4.2 Overview of embedded derivatives and terminology
Publication date: 29 Nov 2020
us Derivatives & hedging guide 4.2
ASC 815-15-20 provides the definition of a hybrid instrument.
Definition from ASC 815-15-20
Hybrid Instrument: A contract that embodies both an embedded derivative and a host contract.
The host contract is the contract or instrument that contains the embedded derivative. Together, they are considered a hybrid instrument. An example of a hybrid instrument is a structured note that pays interest based on changes in the S&P 500 Index; the component of the contract that adjusts the interest payments based on changes in the S&P 500 Index is the embedded derivative. The debt instrument that pays interest (without the S&P 500 Index adjustment) and will repay the principal amount is the host contract.
Sometimes, the determination of the host contract and embedded derivative will be straightforward. More often, this will require judgment. Figure DH 4-1 lists some embedded components commonly found in contracts and instruments.
Figure DH 4-1
Examples of embedded components that may be embedded derivatives
Examples of embedded components that may be embedded derivatives
Type of contract or instrument
|
Potential embedded derivatives
|
Debt instrument
|
Put or call option
Interest rate indexation or leverage
Credit indexation (other than issuer’s own credit)
Conversion option
Foreign exchange indexation
|
Preferred stock
|
Put or call option
Conversion option
|
Insurance
|
Equity indexation
Variable annuity minimum guarantees
|
Lease
|
Interest rate indexation or leverage
Credit indexation
|
Purchase contract
|
Interest rate indexation or leverage
Credit indexation
Commodity price risk
|
Question DH 4-1 discusses whether a reporting entity should assess contracts that are reported at fair value with fair value recorded in earning to determine whether they contain an embedded derivative.
Question DH 4-1
Should a reporting entity assess contracts that are reported at fair value with changes in value recorded in earnings to determine whether they contain embedded derivatives?
Should a reporting entity assess contracts that are reported at fair value with changes in value recorded in earnings to determine whether they contain embedded derivatives?
PwC response
No. A reporting entity does not have to assess whether contracts measured at fair value through earnings contain embedded derivatives. Separating an embedded derivative from a host contract measured at fair value through earnings is unnecessary since the hybrid instrument (which combines the host contract and the derivative) is already reported at fair value through earnings.
Question DH 4-2 discusses if entity can separate a separately identifiable derivative from a contract that meets the definition of a derivate in its entirety.
Question DH 4-2
Can a reporting entity separate a separately identifiable derivative from a contract that meets the definition of a derivative in its entirety (i.e., can it separate a compound derivative into its components)?
Can a reporting entity separate a separately identifiable derivative from a contract that meets the definition of a derivative in its entirety (i.e., can it separate a compound derivative into its components)?
PwC response
No. ASC 815 does not allow a reporting entity to separate a compound derivative into its components. The entire derivative should be measured at fair value through earnings.
Question DH 4-3 asks whether an entity can elect to separate an embedded derivative from a hybrid instrument if ASC 815 does not require it to be separated.
Question DH 4-3
May a reporting entity elect to separate an embedded derivative from a hybrid instrument if ASC 815 does not require it to be separated?
May a reporting entity elect to separate an embedded derivative from a hybrid instrument if ASC 815 does not require it to be separated?
PwC response
No. As discussed in ASC 815-15-25-1, an embedded derivative should be separated from its host contract and accounted for as a derivative instrument “if and only if” all of the specified criteria are met. Accordingly, a reporting entity may not separate an embedded derivative instrument from a hybrid instrument unless the criteria for separation in ASC 815 are met. However, a reporting entity may be allowed to apply the fair value option to the entire hybrid instrument. See DH 4.3.2.1 and FV 5 for information on the fair value option.
4.2.1 Identifying an embedded derivative
Determining whether a contract contains an embedded derivative, and the terms of that embedded derivative, can be complicated. Because few contracts actually use the term “derivative,” a thorough evaluation of the contractual and implicit terms of an instrument or contract is needed to determine whether an embedded derivative exists. Certain terms and phrases, however, may indicate the presence of an embedded derivative. Such terms and phrases include:
- Right to put / call / redeem / repurchase / return
- Right to prepay / repay early / accelerate repayment / early exercise
- Right to purchase / sell additional units
- Right to terminate / cancel / extend
- Right to exchange / exchangeable into
- Right to convert / convertible into
- Indexed to / adjusted by / referenced to
- Pricing based on the following formula
- Option between / choice between
- Notional / underlying / strike / premium
- Conditional / contingent / optional
One method of determining whether a contract has an embedded derivative is to compare the terms of the contract (e.g., interest rate, maturity date, cancellation provisions) with the corresponding terms of a similar, plain-vanilla version of the contract. This comparison may uncover one or more embedded derivatives. However, even instruments with typical market terms may contain embedded derivatives.
4.2.1.1 Determining whether a component is freestanding or embedded
A component can be embedded in a host instrument or contract that has economic value other than the component (e.g., a debt instrument). Alternatively, an instrument can comprise only the component, as is the case with a freestanding warrant. The term “freestanding” also applies to a single financial instrument that comprises more than one option or forward component, for example, a collar, which consists of a written put option and a purchased call option.
Determining whether a component is freestanding or embedded is important because although both may be subject to the guidance in ASC 815, the criteria used to determine the accounting recognition and measurement for freestanding instruments differs from the criteria for embedded components.
The ASC Master Glossary provides a definition of a freestanding financial instrument.
Definition from ASC Master Glossary
Freestanding Financial Instrument: A financial instrument that meets either of the following conditions:
a. It is entered into separately and apart from any of the entity’s other financial instruments or equity transactions.
b. It is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.
In determining whether a component is a freestanding financial instrument or embedded in a host instrument, a reporting entity should consider all substantive terms. A reporting entity should first determine whether the components are issued (1) contemporaneously and in contemplation of each other or (2) separately and at different points in time. A put or call exercisable with a third party (whether added contemporaneously with or after issuance) would be accounted for separately.
Next, a reporting entity should consider whether the components (1) may be legally transferred separately, or (2) must be transferred with the instrument with which they were issued or associated. Components that may be legally transferred separately are generally freestanding. However, a component that must be transferred with the instrument with which it was issued or associated is not necessarily embedded; it may merely be attached.
A reporting entity should also consider whether a right in a component (1) may be exercised separately from other components that remain outstanding or (2) if once a right in a component is exercised, the other components are no longer outstanding. Since separate exercisability invariably requires the component to first be detached prior to exercise, this is a strong indicator that the component is freestanding.
See FG 5.3 for an example illustrating an evaluation of whether a component is a freestanding financial instrument or embedded in a host contract.
4.2.2 Identifying the host contract
A host contract is the instrument or contract that would have been issued if the hybrid instrument did not contain an embedded derivative. Each embedded derivative is compared to its host contract to determine if it should be accounted for separately from the host instrument. Therefore, it is necessary to determine the nature of the host contract based on its underlying economic characteristics and risks.
Figure DH 4-2 lists some common host contracts and where they are discussed in this chapter.
Figure DH 4-2
Types of host contracts
Types of host contracts
Financial instruments classified as liabilities on the issuer’s balance sheet are generally debt hosts; financial instruments classified as equity on the issuer’s balance sheet may be equity or debt hosts. See DH 4.5.1 for information on determining whether an equity instrument is a debt or equity host.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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