What is an embedded derivative?
An embedded derivative is a provision in a contract that modifies the cash flow of a contract, making it dependent on some underlying measurement. Like traditional derivatives, embedded derivatives can be based on a variety of instruments, from common stock to exchange rates and interest rates. The combination of derivatives with traditional contracts, or the incorporation of derivatives, changes the way risk is distributed between 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 standalone and independently traded. Embedded derivatives are embedded in 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, 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 about rising interest rates, but your rate will be locked at a lower rate. You can modify the loan agreement by incorporating a derivative so that interest payments depend on another measure. They can, for example, be adjusted according to a benchmark interest rate or a stock market index.
Embedded derivatives are found in many types of contracts. They are often used in leasing and insurance contracts. Preferred shares and convertible bonds, or bonds that can be exchanged for shares, also harbor embedded derivatives. The specific accounting principles for embedded derivatives are complicated, but the basic concepts are that the embedded derivative should be accounted for at fair value and that it should only be accounted for separately from the host contract if it can be considered a traditional derivative.
An embedded derivative contract can replace another type of risk management; For example, some companies do business in more than one currency. By paying production costs in one currency and selling the product in another, they risk adverse fluctuations in interest rates. Often these companies engage 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 where the buyer now bears the risk, where a third party traded independent futures with the corporation.
This example illustrates the main function of embedded derivatives: transferring risk. They change the terms of a traditional contract so that the party that would be subject to the risk associated with, for example, interest rates or exchange rates, is protected, while the other party is exposed. Embedded derivatives are used to convince investors to enter otherwise unattractive contracts, making contracts less risky.