IFRS 9 Financial Instruments: Derivatives and Embedded Derivatives: Definitions and Characteristics

The distinction between a derivative and non-derivative financial instrument is an important one as derivatives (with certain exceptions) are carried at fair value with changes impacting P/L. A derivative is defined in IFRS 9 (Appendix A) as a financial instrument or other contract within the scope of IFRS 9 with all three of the following characteristics:

(a) its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘underlying’).

(b) it requires 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.

(c) it is settled at a future date.

It is usually apparent whether a financial instrument is a derivative or not, but there are also more complex issues in the financial world. Examples of derivatives are given in paragraph IFRS 9 IG B.2.

Changes in value of a derivative usually result from the fact that it has an underlying notional amount, for example an amount of currency units or a number of shares. For example, a fair value of a forward contract to convert $10 million to EUR at a fixed exchange rate in 6 months will change along with market exchange rates $ to EUR proportionately to the $10 million notional amount. However it is also possible for a derivative to require a fixed payment or payment of an amount that can change (but not proportionally with a change in the underlying) as a result of some future event that is unrelated to a notional amount. For example, a contract may require a fixed payment of $1,000 if six-month LIBOR increases by 100 basis points. Such a contract is a derivative even though a notional amount is not specified (IFRS 9.BA.1).

Point (a) in the definition above includes an exception relating to non-financial variable specific to a party to the contract (e.g. a fire that damages or destroys a property of an entity). This exception does not relate to variables that are only loosely related to the entity (e.g. most weather derivatives) (IFRS 9.BA.5). In short, this exception is intended to exclude insurance contracts from the scope of IFRS 9, but it can apply also to other contracts as there is no consensus what exactly is a non-financial variable, e.g. financial indicators of an entity’s performance.

It will be usually clear that a financial instrument meets point (b) of the derivative definition. IFRS 9 clarifies also that this condition is met for options (despite premium paid/received) and swaps that require initial exchange of different currencies (IFRS 9.BA.3).

The assessment of whether a prepaid contract meets the ‘no or insignificant net investment’ criterion can get tricky. See paragraphs IFRS 9 IG B.4, B.5 and B.9 for more discussion and examples.

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

A derivative contract is settled at a future date and it does not matter whether the settlement is gross or net (IFRS 9 IG B.3). Expiration of unexercised option is also a form of settlement (IFRS 9 IG B.7).

IFRS 9 requires aggregation of non-derivative transactions if they are in substance a derivative transaction. Indicators of such an instance with an example are given in paragraph IFRS 9 IG B.6.

A regular way purchase or sale usually gives rise to a fixed price commitment between trade date and settlement date which technically meets the definition of a derivative. However, such contracts are not accounted for as derivatives as IFRS 9 contains special accounting requirements for such contracts, which are discussed below (IFRS 9.BA.4).

Contracts to buy or sell non-financial items (including own use exemption) are discussed in IAS 32.

IFRS 9 contains specific requirements concerning embedded derivatives so that an entity will not be able to bypass the recognition and measurement requirements for derivatives by embedding a derivative in 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—with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative (IFRS 9.4.3.1).

Embedded derivatives are not separated for accounting purposes if the non-derivative host is a financial asset within the scope of IFRS 9 (IFRS 9.4.3.2), i.e. the classification criteria of IFRS 9 are applied to the financial asset as a whole.

An embedded derivative is separated from the host contract if, and only if (IFRS 9.4.3.3):

(a) the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host;

(b) a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and

(c) the hybrid contract is not measured at fair value with changes in fair value recognised in profit or loss (i.e. a derivative that is embedded in a financial liability at fair value through profit or loss is not separated).

A derivative that is attached to a financial instrument but is contractually transferable independently of that instrument, or has a different counterparty, is not an embedded derivative, but a separate financial instrument (IFRS 9.4.3.1).

Interestingly, ‘closely related’ is not directly defined in IFRS 9. Instead, there are examples that illustrate what is meant and why. Paragraph IFRS 9.B4.3.5 provides 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 opposite situation. These two paragraphs are discussed below.

Indexing an interest rate on a debt instrument is by far the most common embedded derivative. A simple loan where interest changes based on LIBOR is a hybrid instrument for which the embedded derivative need not be separated. However there can be more complex 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 met (IFRS 9.B4.3.8(a)):

1/ the hybrid contract can be settled in such a way that the holder would not recover substantially all of its recognised investment (the holder must be required, not simply permitted, to accept such a settlement – see IFRS 9 IG.C10) or

2/ points (i) and (ii) are both met:

  1. the embedded derivative could at least double the holder’s initial rate of return on the host contract and
  2. 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 floor and caps are closely related to the host contract and need not be separated if (IFRS 9.B4.3.8(b)):

  • the cap is at or above the market rate of interest or the floor is at or below the market rate of interest when the contract is issued and
  • they are not leveraged.

This criterion proved to be particularly challenging in low or even negative interest environments where floors above current spot rates were increasingly popular.  The most common approach in such a case is to compare the cap/floor to current swap rates, but it is possible to develop more sophisticated methods of determining market rate of interest to be compared with caps/floors, such as average forward interest rates during the life of a host contract.

See January 2016 IFRIC update for more discussion (point ‘Separation of an embedded floor from a floating rate 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 (for example, a dual currency bond) is closely related to the host debt instrument and need not be separated (IFRS 9.B4.3.8(c)).

An embedded foreign currency derivative in a host contract that is a contract for the purchase or sale of a non-financial item denominated in a foreign currency (not a financial instrument in general) need not be separated if all of the following criteria are met (IFRS 9.B4.3.8(d)):

  • it is not leveraged (see also 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) (see also IFRS 9 IG.C.7,C.9)

It is sometimes challenging in practice to determine 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’ as IFRS 9 contains no guidance in this respect. Judgement needs to be applied by entities.

Inflation linked contracts for the purchase or sale of a non-financial item are a common occurrence is business world, yet there are not given as an example in IFRS 9. However, paragraph IFRS 9. B4.3.8(f)(i) relates to an embedded derivative that is a an inflation-related index. Such an embedded derivative need not be separated if it is no leveraged and the index relates to inflation in the entity’s own economic environment. This criteria may well be applied to regular contracts for the purchase or sale of a non-financial item as well.

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 need not be separated if there is a concurrent adjustment to the approximate current market rate of interest at the time of the extension (IFRS 9.B4.3.5(b)). For fixed-rate extension options this means that an embedded derivative needs to be separated if there is no adjustment to the current market rate of interest.

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

(i) the option’s exercise price is approximately equal on each exercise date to the amortised cost of the host debt instrument or the carrying amount of the host insurance contract; or

(ii) the exercise price of a prepayment option reimburses the lender for an amount up to the approximate present value of lost interest for the remaining term of the host contract.

The lost interest can be understood as the difference between the effective interest rate on the host contract and the effective interest rate that can be earned on a contract with similar characteristics and similar remaining term at the exercise of the option.

Specific provisions relating to prepayment option in an interest-only or principal-only strips are given in paragraph IFRS 9.B4.3.8(e).

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

A puttable instrument is a hybrid financial instrument where the holder can require the issuer to reacquire the instrument (i.e. put it back to the issuer). When such an option is for an amount of cash or other assets that varies on the basis of the change in an equity or commodity price or index, such an embedded derivative is not closely related to host contract and should be separated, unless the issuer on initial recognition designates the puttable instrument as a financial liability at fair value through profit or loss (IFRS 9.B4.3.5(a); B4.3.6).

In the case of 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 (such as 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 is to measure the hybrid contract at the redemption amount that is payable at the end of the reporting period if the holder exercised its right to put the instrument back to the issuer (IFRS 9.B4.3.7).

An embedded non-option derivative (such as an embedded forward or swap) is separated from its host contract on the basis of its stated or implied substantive terms, so as to result in it having a fair value of zero at initial recognition (IFRS 9.B4.3.3). In the absence of implied or stated terms, the entity makes its own judgement of the terms, see paragraph IFRS 9 IG C.1 for more 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. The functional currency of both entities is EUR and USD does not meet any of the conditions set out in paragraph IFRS 9.B4.3.8(d), therefore the embedded derivative should be separated from the host contract. The forward exchange rate EUR/USD for 1 October is 1.1 (1 EUR = 1.1 USD).

The hybrid contract is therefore split into:

  1. embedded derivative: pay USD 1 million and receive EUR 909,091
  2. host (service) contract: pay EUR 909,091

An embedded option-based derivative (such as an embedded put, call, cap, floor or swaption) is separated from its host contract on the basis of the stated terms of the option feature. The initial carrying amount of the host instrument is the residual amount after separating the embedded derivative (IFRS 9.B4.3.3). Contrary to non-option embedded derivatives, option-based embedded derivatives will have a zero fair value at the inception due to their nature, see paragraph IFRS 9 IG C.2 for more discussion.

Generally speaking, multiple embedded derivatives in a single hybrid contract are treated as a single compound embedded derivative. However, if a hybrid contract has more than one embedded derivative and those derivatives relate to different risk exposures and are readily separable and independent of each other, they are accounted for separately from each other (IFRS 9.B4.3.4).

If an entity is unable to measure the embedded derivative separately, the fair value of the embedded derivative should be determined as the difference between the fair value of the hybrid contract and the fair value of the host (IFRS 9.4.3.7). If this is also not possible, the entire hybrid contract is designated as at fair value through profit or loss (IFRS 9.4.3.6).

See other pages relating to IFRS 9:

IFRS 9 Financial Instruments: Scope and Initial Recognition

IFRS 9 Financial Instruments: Classification of Financial Assets and Financial Liabilities

IFRS 9 Financial Instruments: Measurement

IFRS 9 Financial Instruments: Impairment

IFRS 9 Financial Instruments: Derecognition of Financial Assets and Financial Liabilities

IFRS 9 Financial Instruments: Hedge Accounting

 


© 2018-2019 Marek Muc

Excerpts from IFRS Standards come from the Official Journal of the European Union (© European Union, https://eur-lex.europa.eu). The information provided on this website does not constitute professional advice and should not be used as a substitute for consultation with a certified accountant.