Derivatives and Embedded Derivatives: Definitions and Characteristics (IFRS 9)

Understanding the difference between derivative and non-derivative financial instruments is crucial, as derivatives (except in specific circumstances) are measured at fair value, with changes affecting P/L, while non-derivative instruments may fall into various measurement categories.

A derivative, as per Appendix A to IFRS 9, is a financial instrument or contract falling within the scope of IFRS 9 and exhibits the following three characteristics:

  • Its value fluctuates in response to changes in an ‘underlying’ variable. This variable could be a specific interest rate, the price of a financial instrument or commodity, a foreign exchange rate, an index of prices or rates, a credit rating or credit index, or another element. If a non-financial variable is involved, it should not be specific to a party in the contract.
  • It requires no initial net investment or an initial net investment smaller than that needed for other contracts showing a similar response to market changes.
  • It is settled at a future date.

It’s usually clear whether a financial instrument is a derivative, but naturally, there are more complex instruments in the financial realm. Examples of derivatives are provided in IFRS 9.IG.B.2 and further discussion can be found in IAS 32.AG15-AG19.

IFRS 9 also introduces the notion of an embedded derivative. This is a component of a combined or hybrid instrument that includes a non-derivative host contract. Under certain conditions, embedded derivatives must be accounted for separately, as if they were distinct financial instruments.

Let’s dive in.


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Changes in value in response to the change in the underlying

A derivative’s value often changes due to it having an underlying notional amount, such as a specific currency amount or a set number of shares. For instance, a fair value of a forward contract, which is to convert USD 10 million to EUR at a fixed exchange rate in 6 months, will change in line with USD/EUR market exchange rates proportionate to the USD 10 million notional amount. However, a derivative can also require a fixed payment or a payment amount that can vary (but not in direct proportion to a change in the underlying) due to some unrelated future event. For example, a contract could stipulate a fixed payment of USD 100,000 if the six-month LIBOR increases by 100 basis points. Such a contract is still a derivative, despite not specifying a notional amount (IFRS 9.BA.1).

The definition above includes an exception pertaining to a non-financial variable specific to a party to the contract, such as a fire that damages or destroys an entity’s property. This exception doesn’t apply to variables that are loosely related to the entity, such as most weather derivatives (IFRS 9.BA.5). In essence, this exception aims to exclude insurance contracts from IFRS 9’s scope. However, it may also apply to other contracts due to the lack of a definitive consensus on what constitutes a non-financial variable. For instance, an entity’s performance indicators could be regarded as non-financial variables specific to a contract party.

No or insignificant net investment

Typical options and swaps

It is typically evident that a financial instrument satisfies the ‘no or insignificant net investment’ criterion specified in the derivative definition. IFRS 9 further clarifies that this condition is fulfilled for options (despite premiums paid or received) and currency swaps that require an initial exchange of different currencies (IFRS 9.BA.3).

Prepaid contracts

Evaluating whether a prepaid contract meets the ‘no or insignificant net investment’ criterion can be complex. For further discussion and examples, refer to paragraphs IFRS 9.IG.B.4-B.5/B.9.

Margin accounts

Paragraph IFRS 9.IG.B.10 specifies that margin accounts do not form part of the initial net investment and should be accounted for as separate assets.

Settlement at a future date

A derivative contract is settled at a future date, regardless of whether the settlement is on a gross or net basis (IFRS 9.IG.B.3). The expiration of an unexercised option also constitutes a form of settlement (IFRS 9.IG.B.7).

Aggregation of non-derivative transactions

IFRS 9 requires the aggregation of non-derivative transactions if they are essentially derivative transactions. Indicators of such situations, along with an example, are provided in paragraph IFRS 9.IG.B.6.

Regular way contracts

A regular way purchase or sale often leads to a fixed price commitment between the trade date and settlement date, which technically fits the definition of a derivative. However, such contracts are not accounted for as derivatives because IFRS 9 stipulates specific accounting requirements for these contracts (IFRS 9.BA.4).

Contracts to buy or sell non-financial items and own use contracts

Contracts to buy or sell non-financial items, including those under the own use exemption, are covered in IAS 32.

Embedded derivatives

IFRS 9 outlines specific requirements regarding embedded derivatives. This ensures that an entity cannot evade the recognition and measurement requirements for derivatives by embedding a derivative into a non-derivative financial instrument or other contract (IFRS 9.BCZ4.92). An embedded derivative is defined as a component of a hybrid contract that also includes a non-derivative host, resulting in some of the combined instrument’s cash flows varying in a manner akin to a standalone derivative (IFRS

It’s crucial to note that embedded derivatives are not separated for accounting purposes if the non-derivative host is a financial asset within the scope of IFRS 9 (IFRS This means that the classification criteria of IFRS 9 are applied to the entire financial asset.

If a hybrid contract contains a host that is not an asset within the scope of IFRS 9, an embedded derivative is separated from the host contract if all the following conditions are satisfied (IFRS

  • The economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host.
  • A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative.
  • The hybrid contract is not measured at fair value with changes in fair value recognised in profit or loss. This implies that a derivative embedded in a financial liability valued at fair value through profit or loss is not separated.

A derivative attached to a financial instrument but contractually independent of that instrument, or with a different counterparty, is not considered an embedded derivative, but a separate financial instrument (IFRS

Let’s consider these criteria in more detail.

Interestingly, ‘closely related’ is not explicitly defined in IFRS 9. Instead, examples are given that demonstrate what is intended and why. Paragraph IFRS 9.B4.3.5 offers examples when economic characteristics and risks of an embedded derivative are not closely related to the host contract, whereas paragraph IFRS 9.B4.3.8 illustrates the contrary situation. These two paragraphs are explored below.

Interest rate indexing

Indexing an interest rate on a debt instrument is the most common embedded derivative. A basic loan where interest varies based on LIBOR is a hybrid instrument for which the embedded derivative need not be separated. However, there can be more intricate arrangements where the assessment will not be straightforward, such as inverse floaters or range floaters.

The embedded derivative should be separated when one of the following two criteria are satisfied (IFRS 9.B4.3.8(a)):

  1. The hybrid contract can be settled in a way that the holder would not recover substantially all of its recognised investment (the holder must be required, not simply allowed, to accept such a settlement – see IFRS 9.IG.C10), or
  2. Both conditions are met:
  • the embedded derivative could at least double the holder’s initial rate of return on the host contract, and
  • the embedded derivative could result in a rate of return that is at least twice what the market return would be for a contract with the same terms as the host contract.

Interest rate floors and caps

Interest rate floors and caps are considered to be closely related to the host contract, hence they do not require separation if they meet the following conditions (IFRS 9.B4.3.8(b)):

  • The cap is at or above the market interest rate or the floor is at or below the market interest rate at the time the contract is issued.
  • They are not leveraged.

This criterion can prove challenging, particularly in low or even negative interest environments where floors above current spot rates are popular. A common approach in such a scenario is to compare the cap/floor to current swap rates. However, it’s also possible to develop more sophisticated methods for determining the market interest rate for comparison with caps/floors, such as the average forward interest rates over the life of a host contract. For further discussion on this topic, refer to this IFRS Interpretations Committee’s agenda decision.

Foreign currency embedded derivatives

An embedded foreign currency derivative that provides a series of principal or interest payments denominated in a foreign currency and is embedded in a host debt instrument (for example, a dual currency bond) is closely related to the host debt instrument and does not require separation (IFRS 9.B4.3.8(c)).

Contracts for the purchase or sale of a non-financial item denominated in foreign currency

An embedded foreign currency derivative within a host contract for the purchase or sale of a non-financial item denominated in a foreign currency does not require separation if it meets all of the following criteria (IFRS 9.B4.3.8(d)):

  • It is not leveraged (also see IFRS 9.IG.C.8).
  • It does not contain an option feature.
  • It requires payments denominated in one of the currencies listed in IFRS 9.B4.3.8(d) (also see IFRS 9.IG.C.7, C.9).

Determining a currency that is ‘commonly used in contracts to purchase or sell non-financial items in the economic environment in which the transaction takes place’ can sometimes be challenging, as IFRS 9 offers no explicit guidance. Entities will need to exercise their judgement in this regard.

Inflation-linked contracts for the purchase or sale of a non-financial item and lease liabilities

Inflation-linked contracts for the purchase or sale of a non-financial item are frequently seen in the business world, although IFRS 9 does not provide explicit examples. Paragraph IFRS 9.B4.3.8(f)(i) pertains to an embedded derivative that is linked to an inflation index. Such an embedded derivative does not require separation if it is not leveraged and the index corresponds to inflation in the entity’s own economic environment. These criteria may well apply to regular contracts for the purchase or sale of a non-financial item as well.

Extension of contract term

An option or automatic provision to extend the remaining term to maturity of a debt instrument is closely related to the host debt instrument and does not require separation if the interest rate is adjusted correspondingly at the time of the extension (IFRS 9.B4.3.5(b)). This implies that an embedded derivative needs to be separated for fixed-rate extension options.

Call, put, or prepayment options

A call, put, or prepayment option embedded in a host debt or insurance contract is closely related to the host contract and does not require separation, according to IFRS 9.B4.3.5(e), if:

  • Option’s exercise price is approximately equal to the amortised cost of the host debt instrument or the carrying amount of the host insurance contract on each exercise date; or
  • Exercise price of a prepayment option reimburses the lender for an amount up to the approximate present value of the interest lost for the remaining term of the host contract.

The ‘lost interest’ refers to the difference between the effective interest rate of the host contract and the effective interest rate obtainable on a contract with similar characteristics and similar remaining term at the time of option exercise. Specific provisions concerning prepayment options in interest-only or principal-only strips can be found in paragraph IFRS 9.B4.3.8(e).

Equity- or commodity-indexing

By definition, interest or principal payments that are equity- or commodity-indexed and embedded in a host debt instrument or insurance contract are not closely related to the host and should thus be separated (IFRS 9.B4.3.5(c)-(d)).

Puttable instruments

A puttable instrument is a hybrid financial instrument where the holder has the right to require the issuer to reacquire the instrument (i.e., ‘put’ it back to the issuer). If such an option depends on the fluctuation of an equity or commodity price or index, this embedded derivative is not closely related to the host contract and should be separated. The exception is if the issuer designates the puttable instrument as a financial liability at fair value through profit or loss on initial recognition (IFRS 9.B4.3.5(a); B4.3.6).

For a puttable instrument that can be put back at any time for cash equal to a proportionate share of the net asset value of an entity (like units of an open-ended mutual fund or some unit-linked investment products), the effect of separating an embedded derivative and accounting for each component results in measuring the hybrid contract at the redemption amount payable at the end of the reporting period if the holder exercised their right to put the instrument back to the issuer (IFRS 9.B4.3.7).

Separation of non-option embedded derivatives

An embedded non-option derivative (such as an embedded forward or swap) is separated from its host contract based on its explicit or implied substantive terms, leading to a fair value of zero at initial recognition (IFRS 9.B4.3.3). If explicit or implied terms are absent, the entity must make a judgement on the terms. See paragraph IFRS 9.IG.C.1 for a more detailed discussion.

Example: Separation of non-option embedded derivatives

On 1 January 20X1, Entity A enters into a service contract with Entity B. Entity A will be required to pay USD 1 million to Entity B on 1 October 20X1. Since both entities use EUR as their functional currency and USD does not fulfil any of the conditions laid out in paragraph IFRS 9.B4.3.8(d), the embedded derivative should be separated from the host contract. The forward exchange rate for EUR/USD on 1 October is 1.1 (1 EUR = 1.1 USD). Consequently, the hybrid contract is divided into:

  • Embedded derivative: pay USD 1 million and receive EUR 909,091; and
  • Host (service) contract: pay EUR 909,091.

Separation of option-based embedded derivatives

An embedded derivative with an option feature, such as a put, call, cap, floor or swaption, is separated from its host contract based on the explicit terms of the option. Following the separation of the embedded derivative, the initial carrying amount of the host instrument becomes the residual amount (IFRS 9.B4.3.3). Unlike non-option embedded derivatives, option-based embedded derivatives inherently have a non-zero fair value at inception, as discussed in IFRS 9.IG.C.2.

Multiple embedded derivatives

As a rule, several embedded derivatives in a single hybrid contract are regarded as a singular compound embedded derivative. However, when a hybrid contract contains multiple embedded derivatives pertaining to distinct risk exposures, and they are easily separable and independent, they are accounted for individually (IFRS 9.B4.3.4).

Inability of separate measurement

If an entity cannot separately measure an embedded derivative, the derivative’s fair value should be computed as the difference between the fair value of the hybrid contract and the fair value of the host (IFRS If this is also unachievable, the entire hybrid contract should be designated at fair value through profit or loss (IFRS

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