Embedded derivatives

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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.

Explanation/example

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.

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