An embedded derivative is part of a financial instrument that also includes a non-derivative host contract. The embedded derivative requires that some portion of the contract’s cash flows be modified in relation to changes in a variable, such as an interest rate, commodity price, credit rating, or foreign exchange rate. If a derivative is contractually transferable separately from the contract, then it is not an embedded derivative.
From IAS 39 to IFRS 9 – reduced complexity
The IAS 39 definition and guidance on separation of embedded derivatives and accounting for hybrid instruments is carried forward to IFRS 9 for instruments where the host contract is not a financial asset within the scope of IFRS 9.
If the host contract is a financial asset within the scope of IFRS 9, the embedded derivative is not separated from the host. Rather, the hybrid instrument is assessed for classification as a whole using the classification requirements for financial assets discussed here.
XYZ Ltd. issues bonds in the market. However, the payment of annual interest and principal component of the bond is indexed with the price of Gold. In such a scenario the payment of annual interest will increase or decrease in direct correlation with the price of gold in the market.
Analysing the case leads to the following determinations:
The bond issued by XYZ ltd. is the debt instrument (Non-derivative), while the interest payments are linked with another instrument which in this case is gold (Derivative component). This derivative component is known as embedded derivative.
The non-derivative component here is also referred as host contract and the combined contract is hybrid in nature.
« Go to IFRS Jargon