GovernanceRegulationIAS 39 – Valuation of Embedded Derivatives

IAS 39 - Valuation of Embedded Derivatives

An embedded derivative is a derivative instrument that is embedded in another contract – the host contract. The host contract might be a debt or equity instrument, a lease, an insurance contract or a sale or purchase contract. IFRS requires all derivatives to be marked-to-market through the income statement, other than qualifying hedging instruments. IFRS requirements on embedded derivatives are designed to ensure that mark-to-market through the income statement cannot be avoided by including – embedding – a derivative in another contract or financial instrument that is not marked-to-market through the income statement.

An embedded derivative can arise from deliberate financial engineering and intentional shifting of certain risks between parties. Many embedded derivatives, however, arise inadvertently through market practices and common contracting arrangements. Even purchase and sale contracts that qualify for executory contract treatment may contain embedded derivatives. An embedded derivative causes modification to a contract’s cash flow, based on changes in a specified variable.

Example

A coal purchase contract may include a clause that links the price of the coal to a pricing formula based on the prevailing electricity price or a related index at the date of delivery. The coal purchase contract, which qualifies for the executory contract exemption, is described as the host contract, and the pricing formula is the embedded derivative. The pricing formula is an embedded derivative because it changes the price risk from the coal price to the electricity price.

Embedded derivatives decision tree

When must embedded derivatives be accounted for?

An embedded derivative is split from the host contract and accounted for separately if:

  • its economics are not ‘closely related’ to those of the host contract;
  • a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and
  • the entire contract is not carried at fair value through profit or loss.

See the decision tree on accounting for embedded derivatives above.

What does ‘closely related’ mean?

IAS 39 does not provide extensive guidance on what ‘closely related’ means, but it relies on an understanding of the concepts and a number of illustrative examples. Many of the examples provided in IAS 39 relate to financial contracts.

An embedded derivative that modifies an instrument’s inherent risk (such as a fixed to floating interest rate swap) would be considered closely related. Conversely, an embedded derivative that changes the nature of the risks of a contract is not closely related.

Most equity- or commodity-linked features embedded in a debt instrument will not be closely related. This includes puts that force the issuer to reacquire an instrument based on changes in commodity price or index, equity or commodity indexed interest or principal payments and equity conversion features. Puts or calls on equity instruments at specified prices (that is, not market on date of exercise) are seldom closely related, neither are calls, puts or prepayment penalties on debt instruments. Credit derivatives embedded in a host debt instrument are seldom closely related to it.

The IAS 39 application guidance provides an illustration of an embedded derivative in a sale or purchase contract, where the price of the asset under the sale or purchase contract is subject to a cap and a floor. The economic characteristics and risks of an embedded derivative are closely related to the economic characteristics and risks of the host contract when the host contract is a debt instrument and the embedded derivative is an interest rate floor or a cap out of the money when the instrument is issued. An entity would not account for the embedded derivative separately from the host contract. The same principle applies to caps and floors in a sale or purchase contract.

Example

A manufacturer enters into a long-term contract to purchase a specified quantity of a commodity from a supplier. In future periods, the supplier will provide the commodity at the current market price but within a specified range. For example, the purchase price may not exceed 120 per unit or fall below 100 per unit; the market price at the inception of the contract is 110 per unit. The commodity-based contract is not within the scope of IAS 39 because it will be settled by delivery in the normal course of business.

The price limits specified in the purchase contract can be viewed as a purchased ‘call’ on the commodity with a strike price of 120 per unit (a cap) and a written ‘put’ on the commodity with a strike price of 100 per unit (a floor). At inception, both the cap and floor on the purchase price are out of the money. They are therefore considered closely related to the host purchase contract and are not recognised as embedded derivatives.

The table below provides further examples of embedded derivatives that are closely related and those that are not.

Contracts for goods and services in a foreign currency

Sales and purchase contracts that are denominated in a foreign currency may include embedded derivatives if the foreign currency is not:

  • a currency in which the product is routinely denominated in international commerce, or
  • the reporting currency of either party to the contract, or
  • a currency commonly used in the economic environment in which the transaction takes place.

Example

A French company sells regularly to customers in the Asia-Pacific region and has a price list denominated in US dollars as well as euros. It agrees a contract with an Australian customer, with payment specified in US dollars. It might agree to do this, for example, if the Australian company has US dollar revenues or simply prefers an exposure in US dollars than in euros.

The forward contract embedded in the sales agreement is separated from the host contract and accounted for as a derivative by the French and the Australian companies. The product is not routinely priced in US dollars in international commerce, the contract is not in the functional currency of either company, and the US dollar is not a currency commonly used for local business transactions in Australia.

Fair valuing embedded derivatives

Embedded derivatives that are separated from the host contract are accounted for at fair value with changes in fair value taken through the income statement. Published price quotations in an active market are normally the best evidence of fair value. Valuation techniques are used to determine the fair value of the derivative if there is no active market that matches the exact terms of the embedded derivative.

Example

A utility has purchased gas under a contract indexed to the prices of gasoil. The gasoil pricing component is an embedded derivative. The host contract (the purchase of gas) is an executory contract and outside the scope of IAS 39. The embedded derivative is a contract for the difference between the gas price and gasoil price. If there is an active and liquid market with forward price curves for gas and gasoil, these prices are obtained and used to value the embedded derivative. If the contract has delivery dates extending over several years, there may not be price quotes for delivery on all relevant dates. Prices are then constructed based on consistent and realistic assumptions about price movements.

Not ‘closely related’
x Equity conversion or ‘put’ option in debt instrument
x Fixed-rate debt extension option
x Debt security with interest or principal linked to commodity or equity prices
x Credit derivatives embedded in a host debt instrument
x Sales or purchases not in
(1) measurement currency of either party,
(2) currency in which products are routinely denominated in international commerce, or
(3) currency commonly used in the economic environment in which the transaction takes place.
Closely related’
x Interest-rate swap embedded in a debt instrument
x Inflation-indexed lease contracts
x Cap and floor in a sale and purchase contract
x Prepayment option in a mortgage where the option’s exercise price is approximately equal to the mortgage’s amortised cost on each exercise date
x A forward foreign exchange contract that results in payments in either party’s reporting currency
x Dual currency bonds
x Foreign currency denominated debt

Valuation techniques are available for almost all embedded derivatives. Assumptions that are made about future prices should be tested, documented and applied consistently. IAS 39 requires the entire contract to be fair valued if an embedded derivative cannot be fair valued separately, with changes in fair value in the income statement.

Considerations for first-time adopters

First-time adopters should take the following steps in relation to embedded derivatives:

  • Scrutinise contracts for embedded derivatives,
  • Determine whether embedded derivatives need to be accounted for separately,
  • Consider what information needs to be collected to assist with the initial recognition and subsequent measurement of embedded derivatives, and
  • Review contracting practices where current practices produce exposure to unwelcome income statement volatility.

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