IFRS 9 - Derivatives

IFRS 9: Derivatives & Embedded Derivatives

Derivatives are financial instruments whose value changes in response to a change in the value of an underlying security, commodity, currency, index or other financial instrument(s). They normally require a zero, or small, initial net investment and are settled at a future date.

IFRS 9 requires derivatives to be recognised when the entity becomes a party to the contractual provisions of the contract, rather than when the contract is settled.

Derivatives are measured at fair value through profit or loss (except for derivatives used as hedging instruments in certain types of hedges).

An embedded derivative is a component of a hybrid instrument that also includes a non-derivative host contract, and which causes some of the cash flows of the combined instrument to vary in a way similar to a standalone derivative.

Where the host contract is a financial asset within the scope of IFRS 9, the whole contract is measured at fair value through profit or loss.

If the host contract is not an asset within the scope of IFRS 9, the embedded derivative should be separated from the host contract and recognised separately as a derivative if:

• Economic characteristics and risks are not closely related to the host contract;
• A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and
• The hybrid instrument is not measured at fair value through profit or loss.

Definition

A derivative is a financial instrument:

• Whose value changes in response to the change in price of an underlying security, commodity, currency, index or other financial instrument(s);
• Where the initial net investment is zero or is small in relation to the value of the underlying security or index; and
• That is settled at a future date

A derivative normally has a notional amount, such as a number of shares or other quantity specified in the contract. For example, a forward currency contract has a quoted amount of currency even though neither the holder nor, writer is required to invest or receive this amount at the inception of the contract.

However, this is not a requirement and a derivative could require a fixed payment or a variable payment based on the outcome of some future event that is unrelated to the notional amount. For example, a contract that requires the fixed payment of £1,000 if a commodity price increases by 5% or more is a derivative.

Common types

Common types of derivatives include the following:

• Swaps
• Purchased or written options (call and put)
• Futures
• Forwards

Underlying variables

Examples of underlying variables attaching to the derivatives include the following:

• Interest rates
• Currency rates
• Commodity prices
• Equity prices
• Credit-related variables

In determining whether a derivative exists, the substance of the transaction should be considered. Non-derivative transactions should be aggregated and treated as derivatives when the transactions result, in substance, in derivatives.

For example, if Entity A grants a fixed rate loan to Entity B and in return Entity B grants a variable rate loan of the same amount and maturity, both entities should treat the arrangement as an interest rate swap and account for it as a derivative.

• A defining characteristic of a derivative is that it requires either no initial investment or an initial net investment smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors. A purchased call option contract, for example, meets this definition because the premium is less than the investment that would be required to obtain the underlying financial instrument to which the option is linked.

• An interest rate swap in which the parties settle on a net basis qualifies as a derivative instrument. This is because the definition of a derivative makes reference to future settlement, but not to the method of settlement.

• If a party prepays its obligation under a pay-fixed, receive-variable interest rate swap at inception, the swap should be classified as a derivative.

• However, if the fixed rate payment obligation is prepaid subsequent to initial recognition this would be regarded as a termination of the old swap and an origination of a new instrument.

• A prepaid pay-variable, receive-fixed interest rate swap is not a derivative if it is prepaid at inception, and it is no longer a derivative if it is prepaid after inception because it provides a return on the prepaid (invested) amount comparable to the return on a debt instrument with fixed cash flows. The prepaid amount fails the ‘no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors’ criterion of a derivative.

• An option which is expected not to be exercised, for example because it is ‘out of the money’, still qualifies as a derivative. This is because an option is settled upon exercise or at its maturity. Expiry at maturity is a form of settlement even though there is no additional exchange of consideration.

• Many derivative instruments, such as futures contracts and exchange-traded written options, require margin accounts. The margin account is not part of the initial net investment in a derivative instrument. Margin accounts are a form of collateral for the counterparty or clearing house and may take the form of cash, securities or other specified assets, typically liquid assets. Margin accounts are separate assets that are accounted for separately.

• A derivative may have more than one underlying variable

• A contract to buy or sell a non-financial asset is a derivative if:

  • it can be settled net in cash or by exchanging another financial instrument; and
  • the contract was not entered for the purpose of receipt or delivery of the non-financial item to meet the entity’s expected purchase, sale or usage requirements

An example would be a gas supply contract in the UK (where there is an active market) where the supplier or purchaser has the right to refuse delivery or receipt of the gas for financial reasons, for example because they can get a better price in the market. However, if the right to refuse delivery on the part of the seller can only be invoked for operational reasons (ie, they do not have the gas available to supply), this does not on its own make the contract a derivative.

Currency Swaps

A currency swap (or cross-currency swap) is an interest rate swap with cash flows in different currencies. It is an agreement to make a loan in one currency and to receive a loan in another currency. With the currency swap there are three sets of cash flows. Initially, the underlying principals are exchanged when the swap starts; interest payments are then made over the life of the swap; and finally the underlying principal amounts are re-exchanged.

A currency swap could also be interpreted as issuing a bond in one currency (and paying interest on this bond) while investing in a bond in another currency (and receiving interest on this bond).

Accounting treatment

Derivatives are classified as held for trading (unless they are hedging instruments), so they should be measured at fair value and changes in fair value should be recognised in profit or loss

Embedded Derivatives

Certain contracts that are not themselves derivatives (and may not be financial instruments) include derivative contracts that are ‘embedded’ within them.

Definition

An embedded derivative is a component of a hybrid (combined) instrument that also includes a non-derivative host contract – with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative.

An embedded derivative causes some or all of the cash flows of the host contract to be modified, based on a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of price or rates, credit rating or credit index, or other variables. As a result, the financial payoffs of the hybrid instrument will resemble those of a standalone derivative.

A key characteristic of embedded derivatives is that the embedded derivative cannot be transferred to a third party independently of the instrument. For example, the embedded equity option in a convertible bond cannot be exercised with the bond being retained. If the conversion option is exercised, the bond will have to be derecognised. This is different from a bond with a detachable warrant, which gives the right to the owner to exercise the warrant and buy shares while retaining the bond. This is not a hybrid or combined instrument. The warrant is a separate financial instrument, not an embedded derivative.

Host contracts examples

Possible examples include the following:

• An investment in a debt instrument that is convertible into ordinary shares of the issuer. The debt instrument is the host contract and the conversion option is the embedded derivative.
• A debt instrument with an extension option with the interest rate in the extension period reset to 1.2 times the market rate. The debt instrument is the host contract with embedded extension option
• A lease contract has a rent adjustment clause based on changes in the local inflation rate. The lease is the host contract with inflation-related rentals being the embedded derivative

Embedded derivative examples

Possible examples include:

• A bond which is redeemable in five years’ time, with part of the redemption price being based on the increase in the FTSE 100 Index:

• A construction contract priced in a foreign currency. The construction contract is a non-derivative contract, but the changes in foreign exchange rate is the embedded derivative.

Accounting treatment

The basic rule for accounting for an embedded derivative is that, if the host contract is a financial asset within the scope of IFRS 9, the whole contract is measured as at fair value through profit or loss.

Separation of host contract, and embedded derivative

If the host contract is not a financial asset within the scope of IFRS 9, the embedded derivative should be separated from its host contract and accounted for separately as a derivative. The purpose is to ensure that the embedded derivative is measured at fair value and any changes in its fair value are recognised in profit or loss.

But this separation should only be made when the following conditions are met:

• The economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host contract
• A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative.
• The hybrid (combined) instrument is not measured at fair value with changes in fair value recognised in profit or loss (if changes in the fair value of the total hybrid instrument are recognised in profit or loss, then the embedded derivative is already accounted for on this basis, so there is no benefit in separating it out).

An entity may, subject to conditions, designate a hybrid contract as at fair value through profit or loss, thereby avoiding the need to measure the fair value of the embedded derivative separately from that of the host contract. The conditions for classifying the entire hybrid contract as at fair value through profit or loss are as follows:

• If the host contract is not an asset within the scope of IFRS 9, an entity may designate the whole contract as at fair value through profit or loss unless:
  • the embedded derivative does not significantly modify the host contract’s cash flows; or
  • it is clear with little or no analysis that separation of the embedded derivative is prohibited, such as a prepayment option embedded in a loan that permits the holder to prepay the loan for approximately its amortised cost.
• If the entity is required to separate the embedded derivative but it cannot be measured separately, the entity may designate the entire contract as at fair value through profit or loss.

If the fair value of the embedded derivative cannot be determined due to the complexity of its terms and conditions, but the value of the hybrid and the host can be determined, then the value of the embedded derivative should be determined as the difference between the value of the hybrid and the value of the host contract.

Identification of embedded derivatives

Embedded derivatives can be structured deliberately, as has been already mentioned, or they may arise inadvertently. An example of this would be a currency that is different from the functional currencies of both the buyer and seller of goods. Multiple embedded derivatives are treated as if they were a single embedded derivative, unless they relate to different risk exposures which can be identified and separated, in which case they can be accounted for separately

Although, theoretically, the host of an embedded derivative could be any type of contract that is not recorded at fair value, in practice there is a small number of contracts that have derivatives embedded in them, the most common of which are:

• Debt instruments
• Equity instruments
• Leases
• Insurance contracts
• Executory contracts such as purchase and sale contracts

The identification of embedded derivatives requires the entity to consider all executory contracts such as operating leases, purchases and sales contracts, and commitments.

For example, an embedded derivative may be identified if contracts contain:

• rights or obligations to exchange at some time in the future;
• rights or obligations to buy or sell;
• provisions for adjusting the cash flows according to some interest rate, price index or specific time period;
• options which permit either party to do something not closely related to the contract; and/or
• unusual pricing terms (eg, a lease which charges interest at rates linked to the FTSE 100 yield contains an embedded swap).

Finally, a comparison of the terms of a contract (such as maturity, cancellation or payment provisions) with the terms of another similar, non-complex contract may indicate the existence, or not, of an embedded derivative.

Not closely related embedded derivatives

Examples where the embedded derivative is not closely related to the host instrument include the following:

• The option to extend the term on a fixed rate debt instrument without resetting the interest rate to market rates
• Credit derivatives in a debt instrument
• A put option embedded in an instrument that enables the holder to require the issuer to reacquire the instrument for an amount of cash or other assets, which varies on the basis of the change in an equity or commodity price or index
• Equity-indexed interest or principal payments embedded in a host debt instrument or insurance contract
• Commodity-indexed interest or principal payments embedded in a host debt instrument or insurance contract
• A call, put, or prepayment option embedded in a host debt contract or host insurance contract
• Credit derivatives that are embedded in a host debt instrument allowing the transfer of credit risk from one party to another.

In all of the above circumstances, the embedded derivative is separated out from the host contract for accounting purposes.

Closely related embedded derivatives

No definition of ‘closely related’ is included in IFRS 9. In general, an embedded derivative is considered to be closely related if it modifies the inherent risk of the combined contract but leaves the instrument substantially unaltered. Some common examples of closely related embedded derivatives are given below.

• An embedded derivative based on an interest rate (or interest rate index) that can change the amount of interest otherwise paid or received on an interest-bearing debt or insurance host contract.
• An embedded floor or cap on the interest rate on a debt contract or insurance contract, provided the floor is at or below, and the cap is at or above, the market rate of interest when the contract is issued, and the cap or floor is not leveraged in relation to the host contract.
• An embedded foreign currency derivative that provides a stream of principal or interest payments that are denominated in a foreign currency and is embedded in a host debt instrument (e.g., a dual currency bond). Such a derivative is not separated from the host instrument because IAS 21 requires foreign currency gains and losses on monetary items to be recognised in profit or loss.
• An embedded foreign currency derivative in a host contract that is an insurance contract or not a financial instrument (such as a contract to purchase a non-financial item where the price is denominated in a foreign currency), provided the payment is to be in the functional currency of one of the substantial parties to the contract, or in the currency in which the contracted good or service is routinely denominated (such as the US dollar for crude oil transactions).
• An embedded prepayment option in an interest-only or principal-only strip is closely related to the host contract provided the host contract initially resulted from separating the right to receive contractual cash flows of a financial instrument that, in and of itself, did not contain an embedded derivative, and does not contain any terms not present in the original host debt contract.
• An embedded derivative in a host lease contract is closely related to the host contract if the embedded derivative is an inflation-related index such as an index, of lease payments to a consumer price index (provided that the lease is not leveraged and the index relates to inflation in the entity’s own economic environment), contingent rentals based on related sales or contingent rentals based on variable interest rates.
• A unit-linking feature embedded in a host financial instrument or host insurance contract is closely related to the host instrument or host contract if the unit-denominated payments are measured at current unit values that reflect the fair values of the assets of the fund. A unit-linking feature is a contractual term that requires payments denominated in units of an internal or external investment fund.
• A derivative embedded in an insurance contract is closely related to the host insurance contract if the embedded derivative and host insurance contract are so interdependent that an entity cannot measure the embedded derivative separately (ie, without considering the host contract).

In all of the above circumstances, the hybrid contract is accounted for as a whole – the embedded derivative is not separated out.

Further Information