Embedded derivative definition
/What is an Embedded Derivative?
An embedded derivative is part of a financial instrument that also includes a non-derivative host contract. The embedded derivative requires that some portion of the contract's cash flows be modified in relation to changes in a variable, such as an interest rate, commodity price, credit rating, or foreign exchange rate. If a derivative is contractually transferable separately from the contract, then it is not an embedded derivative.
Example of an Embedded Derivative
As an example of an embedded derivative, a business issues a convertible bond. This financial instrument is primarily a bond, but also includes an embedded derivative that gives the bond holder the right to convert the bond into a specific number of shares of the bond issuer.
Presentation of an Embedded Derivative
When an embedded derivative can be separated from the host contract, then the derivative should be presented separately on the reporting entity’s balance sheet at its fair value. In addition, any changes in the derivative’s fair value should be recorded in earnings for the current period.