IFRS 9 Derivatives and Embedded Derivatives
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Here we are
going to elaborate about ‘Derivatives’ and ‘Embedded derivatives’
according to ‘IFRS
9- Financial Instrument’ accounting standard. Follow the below article to know
about what’s derivative and how do we measure that under IFRS 9.
What
is derivative?
Derivative
is a financial instrument or other contract within the scope of this
Standard 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 (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.
Below are
few examples of contract that’s normally qualified as derivatives under IFRS 9:
Type of
contracts
|
Underlying
variable
|
Interest rate swap
|
Interest rates
|
Currency swap
|
Currency rates
|
Commodity swap
|
Commodity prices
|
Equity swap
|
Equity prices (equity of another
entity)
|
Few
examples of Derivatives:-
Example 1
Entity
X enters into an interest rate swap with a counterparty (A) that requires X to
pay a fixed rate of 8 per cent and receive a variable amount based on
three-month LIBOR, reset on a quarterly basis. The fixed and variable amounts
are determined on the basis of a CU100 million notional amount. X and A, do not
exchange the notional amount. X pays or receives a net cash amount each quarter
based on the difference between 8 per cent and three-month LIBOR.
Alternatively, settlement may be on a gross basis.
Analysis
The
contract meets the definition of a derivative regardless of whether there is
net or gross settlement because its value changes in response to changes in an
underlying variable (LIBOR), there is no initial net investment, and
settlements occur at future dates.
Example 2
Entity
A makes a five-year fixed rate loan to Entity B, while B at the same time makes
a five-year variable rate loan for the same amount to A. There are no transfers
of principal at inception of the two loans, since A and B have a netting
agreement. Is this a derivative under IFRS 9?
Analysis
Yes.
This meets the definition of a derivative (that is to say, there is an
underlying variable, 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, and future
settlement). The contractual effect of the loans is the equivalent of an
interest rate swap arrangement with no initial net investment. Non-derivative
transactions are aggregated and treated as a derivative when the transactions
result, in substance, in a derivative. Indicators of this would include:
•they
are entered into at the same time and in contemplation of one another
•they
have the same counterparty
•they
relate to the same risk
•there
is no apparent economic need or substantive business purpose for structuring
the transactions separately that could not also have been accomplished in a
single transaction.
The
same answer would apply if Entity A and Entity B did not have a netting
agreement, because the definition of a derivative instrument in IFRS 9 does
not require net settlement.
Measurement
of Derivatives in IFRS 9- All derivatives in scope
of IFRS 9, including those linked to unquoted equity investments, are measured
at fair value. Fair value changes are recognised in profit or loss unless the
entity has elected to apply hedge accounting by designating the derivative as a
hedging instrument in an eligible hedging relationship in which some or all
gains or losses may be recognised in other comprehensive income.
What
does Embedded derivative mean?
An
embedded derivative is 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.
An
embedded derivative causes some or all of the cash flows that otherwise would
be required by the contract to be modified according to 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.
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.
Introduction of Hybrid
contracts:-
Hybrid contracts with
financial asset hosts:
If a
hybrid contract contains a host that is an asset within the scope of
this Standard, an entity shall apply the requirements of IFRS 9 classification
to the entire hybrid contract.
Other hybrid
contracts:
If a
hybrid contract contains a host that is not an asset within the scope of
this Standard, an embedded derivative shall be separated from the host and
accounted for as a derivative under this Standard if, and only if:
(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 (ie a derivative that is embedded in a financial
liability at fair value through profit or loss is not separated).
Separation guidance on Embedded
derivatives:
IFRS 9
retains the IAS 39 definition of an embedded derivative and most of the
associated guidance on separation. However, if the host contract is an asset in
the scope of IFRS 9 then the embedded derivative is not separated but instead
the whole hybrid instrument is assessed for classification. Refer following
points for more insights:
Ø If an embedded derivative is
separated, the host contract shall be accounted for in accordance with the
appropriate Standards. This Standard does not address whether an embedded
derivative shall be presented separately in the statement of financial
position.
Ø Equity/Debt host- If a host contract has no stated or
predetermined maturity and represents a residual interest in the net assets of
an entity, then its economic characteristics and risks are those of an equity
instrument, and an embedded derivative would need to possess equity
characteristics related to the same entity to be regarded as closely related.
If the host contract is not an equity instrument and meets the definition of a
financial instrument, then its economic characteristics and risks are those of
a debt instrument.
Ø Non‑option derivative -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. 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.
Ø Generally,
multiple embedded derivatives in a single hybrid contract are treated as a
single compound embedded derivative. However, embedded derivatives that are
classified as equity (see IAS 32 Financial Instruments: Presentation) are
accounted for separately from those classified as assets or liabilities. In
addition, 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
Ø An example
of a hybrid contract is a financial instrument that gives the holder a right to
put the financial instrument back to the issuer in exchange for an amount of
cash or other financial assets that varies on the basis of the change in an
equity or commodity index that may increase or decrease (a ‘puttable
instrument’). Unless the issuer on initial recognition designates the puttable
instrument as a financial liability at fair value through profit or loss, it is
required to separate an embedded derivative (ie the indexed principal payment) because
the host contract is a debt instrument and the indexed principal payment is not
closely related to a host debt instrument. Because the principal payment can
increase and decrease, the embedded derivative is a non‑option derivative whose value is
indexed to the underlying variable.
Ø 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.
Measurement of Separated Embedded
Contract:-
Ø If a contract contains one
or more embedded derivatives and the host is not an asset within the scope
of this Standard, an entity may designate the entire hybrid contract as at
fair value through profit or loss unless:
(a) the embedded derivative do not significantly
modify the cash flows that otherwise would be required by the contract; or
(b) it is clear with little or no analysis when a
similar hybrid instrument is first considered that separation of the embedded
derivative(s) is prohibited, such as a prepayment option embedded in a loan
that permits the holder to prepay the loan for approximately its amortised
cost.
Ø If an entity is required by
this Standard to separate an embedded derivative from its host, but is unable
to measure the embedded derivative separately either at acquisition or at the
end of a subsequent financial reporting period, it shall designate the entire
hybrid contract as at fair value through profit or loss.
Ø If an entity is unable to
measure reliably the fair value of an embedded derivative on the basis of its
terms and conditions, the fair value of the embedded derivative is the
difference between the fair value of the hybrid contract and the fair value of
the host. If the entity is unable to measure the fair value of the embedded
derivative using this method, the hybrid contract is designated as at fair
value through profit or loss.
Examples - An
entity does accounts for the embedded derivative
separately from the host contract:
(a)
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 that
varies on the basis of the change in an equity or commodity price or index is
not closely related to a host debt instrument.
(b)
An option or automatic provision to extend the remaining term to maturity of a
debt instrument is not closely related to the host debt instrument unless there
is a concurrent adjustment to the approximate current market rate of interest
at the time of the extension. If an entity issues a debt instrument and the
holder of that debt instrument writes a call option on the debt instrument to a
third party, the issuer regards the call option as extending the term to
maturity of the debt instrument provided the issuer can be required to
participate in or facilitate the remarketing of the debt instrument as a result
of the call option being exercised.
(c)
Equity‑indexed interest or principal
payments embedded in a host debt instrument or insurance contract—by which the
amount of interest or principal is indexed to the value of equity
instruments—are not closely related to the host instrument because the risks
inherent in the host and the embedded derivative are dissimilar.
(d)
Commodity‑indexed interest
or principal payments embedded in a host debt instrument or insurance contract—by
which the amount of interest or principal is indexed to the price of a
commodity (such as gold)—are not closely related to the host instrument because
the risks inherent in the host and the embedded derivative are dissimilar.
(e)
A call, put, or prepayment option embedded in a host debt contract or host
insurance contract is not closely related to the host contract unless:
(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. Lost interest is the product of the principal amount prepaid
multiplied by the interest rate differential. The interest rate differential is
the excess of the effective interest rate of the host contract over the
effective interest rate the entity would receive at the prepayment date if it
reinvested the principal amoun prepaid in a similar contract for the remaining
term of the host contract.
The
assessment of whether the call or put option is closely related to the host
debt contract is made before separating the equity element of a convertible
debt instrument in accordance with IAS 32.
(f)
Credit derivatives that are embedded in a host debt instrument and allow one
party (the ‘beneficiary’) to transfer the credit risk of a particular reference
asset, which it may not own, to another party (the ‘guarantor’) are not closely
related to the host debt instrument. Such credit derivatives allow the
guarantor to assume the credit risk associated with the reference asset without
directly owning it.
Examples - An
entity does not account for the embedded
derivative separately from the host contract:
(a)
An embedded derivative in which the underlying is an interest rate or interest
rate index that can change the amount of interest that would otherwise be paid
or received on an interest‑bearing host debt contract or insurance contract is closely
related to the host contract unless the hybrid contract can be settled in such
a way that the holder would not recover substantially all of its recognised
investment or the embedded derivative could at least double the holder’s
initial rate of return on the host contract and 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.
(b)
An embedded floor or cap on the interest rate on a debt contract or insurance
contract is closely related to the host contract, provided the cap is at or
above the market rate of interest and the floor is at or below the market rate
of interest when the contract is issued, and the cap or floor is not leveraged
in relation to the host contract. Similarly, provisions included in a contract
to purchase or sell an asset (eg a commodity) that establish a cap and a floor
on the price to be paid or received for the asset are closely related to the
host contract if both the cap and floor were out of the money at inception and
are not leveraged.
(c)
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. Such a derivative is not separated from the host
instrument because IAS 21 The Effects of Changes in Foreign Exchange Rates
requires foreign currency gains and losses on monetary items to be recognised
in profit or loss.
(d)
An embedded foreign currency derivative in a host contract that is an insurance
contract or not a financial instrument (such as a contract for the purchase or
sale of a non‑financial item
where the price is denominated in a foreign currency) is closely
related to the host contract provided it is not leveraged, does not contain an
option feature, and requires payments denominated in one of the following
currencies:
(i)
the functional currency of any substantial party to that contract;
(ii)
the currency in which the price of the related good or service that is acquired
or delivered is routinely denominated in commercial transactions around the
world (such as the US dollar for crude oil transactions); or
(iii)
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 (eg a relatively stable and
liquid currency that is commonly used in local business transactions or
external trade).
(e) An embedded prepayment option in an
interest‑only or principal‑only strip is closely related to the
host contract provided the host contract (i) 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 (ii) does not contain any
terms not present in the original host debt contract
(f)
An embedded derivative in a host lease contract is closely related to the host
contract if the embedded derivative is (i) 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), (ii)
variable lease payments based on related sales or (iii) variable lease payments
based on variable interest rates.
(g)
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.
(h)
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).
Instruments
containing embedded derivatives:
When
an entity becomes a party to a hybrid contract with a host that is not an asset
within the scope of this Standard and with one or more embedded derivatives, it
requires the entity to identify any such embedded derivative, assess whether it
is required to be separated from the host contract and, for those that are
required to be separated, measure the derivatives at fair value at initial
recognition and subsequently. These requirements can be more complex, or result
in less reliable measures, than measuring the entire instrument at fair value
through profit or loss. For that reason this Standard permits the entire hybrid contract to be designated
as at fair value through profit or loss.
Reassessment
of embedded derivatives:
An
entity shall assess whether an embedded derivative is required to be separated
from the host contract and accounted for as a derivative when the entity first
becomes a party to the contract. Subsequent reassessment is prohibited
unless there is a change in the terms of the contract that significantly
modifies the cash flows that otherwise would be required under the contract, in
which case reassessment is required. An entity determines whether a
modification to cash flows is significant by considering the extent to which
the expected future cash flows associated with the embedded derivative, the
host contract or both have changed and whether the change is significant
relative to the previously expected cash flows on the contract.
It
does not apply to embedded derivatives in contracts acquired in:
(a)
a business combination (as defined in IFRS 3 Business Combinations);
(b)
a combination of entities or businesses under common control as described in
paragraphs B1–B4 of IFRS 3; or
(c)
the formation of a joint venture as defined in IFRS 11 Joint Arrangements or
their possible reassessment at the date of acquisition.3
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