Combining derivatives with traditional contracts, or incorporating derivatives, changes the way risk is distributed between contract parties.
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. Combining derivatives with traditional contracts, or incorporating derivatives, changes the way risk is distributed between contract parties.
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; its location, however, is different. Traditional derivatives are standalone and independently traded. Embedded derivatives are embedded in a contract, called the 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 take out a loan, you agree to repay the funds plus interest. When you enter into this contract, the lender fears that interest rates will go up, but your rate will be locked in at a lower rate. It can modify the loan agreement by incorporating a derivative so that interest payments depend on another measurement. They could, for example, be adjusted according to a benchmark interest rate or a stock index.
Embedded derivatives are found in many types of contracts. They are often used in leases and insurance contracts. Preferred shares and convertible bonds, or bonds that can be exchanged for shares, also host 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.
A contract with an embedded derivative can replace another type of risk management; for example, some companies conduct 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 participate in foreign exchange futures trading to hedge the risk they face. Another option is to incorporate the foreign exchange futures into the sales contract. This differs from the original strategy in that the buyer now faces risk, where a third party has traded independent futures with the corporation.
This example illustrates the primary function of embedded derivatives: transferring risk. They change the terms of a traditional contract so that the party that would be subject to the associated risk, for example interest or exchange rates, is protected, while the other party is exposed. Embedded derivatives are used to convince investors to enter unattractive contracts, making the contracts less risky.