Embedded derivatives modify cash flow in contracts based on underlying measurements, transferring risk between parties. They are found in various contracts and can substitute for other risk management strategies. Their accounting principles are complex, and they are used to make contracts less risky for investors.
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 shares to foreign exchange rates and interest rates. Combining derivatives with traditional contracts, or incorporating derivatives, changes the way 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; their placement, however, is different. Traditional derivatives are independent and traded independently. Embedded derivatives are incorporated into a contract, called a 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 apply for a loan, you agree to pay the funds plus interest. When you sign this contract, the lender is concerned that interest rates will go up, but your rate will be locked into a lower rate. You can modify the loan agreement by incorporating a derivative so that interest payments depend on another measurement. They could, for example, be adjusted according to a reference 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 stocks and convertible bonds, or bonds that can be exchanged for shares, also house embedded derivatives. The specific accounting principles for embedded derivatives are complicated, but the basics are that the embedded derivative should be accounted for at its fair value and that it should only be accounted for 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 risk adverse interest rate fluctuations. Often these companies participate in currency futures trading to hedge the risk they face. Another option is to integrate currency futures into the sales contract. This differs from the original strategy in that the buyer now bears the risk, in which a third party independently traded futures with the corporation.
This example illustrates the main function of embedded derivatives: to transfer risk. They change the terms of a traditional contract so that the party that would have been subject to risk associated with, for example, interest rates or foreign exchange rates, is protected, while the other party is exposed. Embedded derivatives are used to convince investors to enter otherwise unattractive contracts by making the contracts less risky.
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