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What are Derivatives?

Derivative is a financial instrument with all three of the following characteristics:

    •    Value changes in response to the changes in an underlying variable such as interest
         rate, commodity or security price, or index;
    •    Requires no initial investment, or one that is smaller than would be required for a
         contract with similar response to changes in market factors; and
    •    Settled at a future date.

Examples of Derivatives:

Forwards: Contracts to purchase or sell a specific quantity of a financial instrument, a
commodity, or a foreign currency at a specified price determined at the outset, with delivery or
settlement at a specified future date. Settlement is at maturity by actual delivery of the item
specified in the contract, or by a net cash settlement.

Interest Rate Swaps and Forward Rate Agreements: Contracts to exchange cash flows as
of a specified date or a series of specified dates based on a notional amount and fixed and
floating rates.

Futures: Contracts similar to forwards but with the following differences: Futures are generic
exchange-traded, whereas forwards are individually tailored. Futures are generally settled
through offsetting (reversing) trade, whereas forwards are generally settled by delivery of the
underlying item or cash settlement.

Options: Contracts that give the purchaser the right, but not the obligation, to buy (call option)
or sell (put option) a specified quantity of a particular financial instrument, commodity, or
foreign currency, at a specified price (strike price), during or at a specified period of time.
These can be individually written or exchange-traded. The purchaser of the option pays the
seller (writer) of the option a fees (premium) to compensate the seller for the risk of payments
under the option

Caps and Floors: These are contracts sometimes referred to as interest rate options. An
interest rate cap will compensate the purchaser of the cap if the interest rates rise above a
predetermined rate (strike rate) while an interest rate floor will compensate the purchaser if
rates fall below a predetermined rate.

Embedded Derivatives                                                                        Page 1
What are Embedded Derivatives?

An embedded derivative is a derivative instrument that is embedded in another contract – the
host contract. The host contract might be a debt or equity instrument, a lease, an insurance
contract or a sales or purchase contract.

Embedded derivative is part of a host contract (a clause or section) which causes the cash
flows from that contract to be modified, based on a specified variable such as interest rate,
security price, commodity price, foreign exchange rate, index of prices or rates or other

Embedded derivatives will have to be identified, separated and marked-to-market through the
income statement.

The Accounting Standard requirements on embedded derivatives are designed to ensure that
mark-to-market through the income statement cannot be avoided by including – embedding –
a derivative in another contract or financial instrument that is not marked-to-market through
the income statement.

Embedded derivative is separated from its host contract and accounted for as a derivative

    •    The economic risks and characteristics of the embedded derivatives are not closely
         related to those of the host contract;
    •    A separate instrument with the same terms as the embedded derivative would meet
         the definition of a derivative; and
    •    The entire contract is not measured at fair value with changes in fair value recognised
         in the income statement.

This is demonstrated by the following decision tree:

Embedded Derivatives                                                                       Page 2
What does ‘closely related’ mean?

An embedded derivative that modifies a contracts inherent risk (such as a fixed or floating
interest rate swap) would be considered closely related. Conversely, an embedded derivative
that changes the nature of the risks of a contract is not closely related.


Closely related:

    •    Inflation linked contracts if not leveraged
    •    Cap and floor in a sale and purchase contract, provided both the cap and floor are out
         of the money on inception and are not leveraged

Not closely related:

    •    Option to extend the remaining term of a debt instrument at a fixed rate
    •    Credit derivatives that are embedded in a debt instrument
    •    Sales and purchases not in:
                        Measurement currency of either party
                        Currency in which the products are routinely dominated in international
                        Currency commonly used in the economic environment in which the
                        transaction takes place

How are they measured?

Embedded derivatives are measured at fair value. If fair value cannot be determined, the
entire contract must be carried at fair value with gains and losses recognised in the income

Embedded Derivatives                                                                      Page 3

1. Coal purchase contract

A contract to purchase coal includes a clause that links the price of the coal to a pricing
formula based on the prevailing electricity price at the date of delivery.

The pricing formula is an embedded derivative because:

         •    The future cash flow will vary with changes in the underlying electricity price
         •    It changes the price risk from coal price to the electricity price

2. Guarantee of a debt instrument

 By having a debt instrument guaranteed by another party (the ‘guarantor’) the credit risk is
transferred to the guarantor. The credit risk associated with the reference asset is assumed
by the guarantor without directly owning it.

Although the economic characteristics of the debt instrument include credit risk, in general the
embedded derivative will be a credit derivative linked to the credit standing of an entity other
than the issuer and therefore is not regarded as closely related.

3. Oil contract in Euros

A UK company agrees to sell oil to a Australian company in Euros, although oil contracts are
routinely in US dollars. Neither company carries out significant activities in Euros.

The UK company should treat the contract as having a embedded foreign currency forward to
purchase euros and the Australian company as a forward contract to sell euros.

The underlying rate of the euro causes the cash flow associated with the contract to vary and
the euro is not considered to be closely related to the supply of oil.

4. Option to purchase equity

A venture capitalist company (CoVC) provides a loan to Company A (CoA). It agrees that in
addition to interest and principal repayments, if CoA lists on the stock exchange, CoVC will be
entitled to purchase shares at a very low price. As a result of this the interest is slightly lower
than it would otherwise be.

The economic characteristics and risks of an equity return are not closely related to those of
the loan. The clause to purchase shares is a derivative because its value changes in relation
to the price of CoA shares, requires only a relatively small initial investment and is settled at a
future date. It does not matter that it is contingent on the future listing of CoA.

Embedded Derivatives                                                                            Page 4

Identification of embedded derivatives

This requires consideration of all financial assets and liabilities that are carried at amortised
cost and all executory-type contracts such as operating leases, purchase and sale contract
and commitments.


    •    Initial assessment, review of contracts and identification of embedded derivatives;

              1. Are there any conditions that will affect some of the future cash flows related
                 to that contract?

              2. Are those changes related to changes in an underlying variable eg interest
                 rate, CPI or index?

              3. Are the risks and characteristics of the embedded derivative closely related to
                 the host contract?

    •    Determine whether embedded derivatives need to be accounted for separately;
    •    Consider what information needs to be collected to assist with the initial recognition
         and subsequent measurement of embedded derivatives; and
    •    Review contracting practices and consider the need for change where current
         practices produce exposure to unwelcome income statement volatility.

Once a potential embedded derivative is identified, you may want to consult with Financial
Services to determine if this needs to be separately accounted for as a derivative.

Embedded Derivatives                                                                       Page 5

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