CFM25030 - Accounting for corporate finance: hybrid debt: embedded derivatives
Convertible debt and exchangeable debt are both examples of an ‘embedded derivative’. A contract is said to contain an embedded derivative when one element of it, which is not transferable independently, has the essential feature of a stand-alone derivative where the whole (termed the ‘host contract’) does not.
In the case of convertible debt, the host contract contains two elements, the bond which may be redeemed at par, and the right of the holder to exchange the bond for shares in the issuing company on set terms at a future date. The latter element is thus a call option to buy shares.
The bond would not qualify as a derivative on the basis of the initial investment, but the option would. There is little or no initial investment, the cost of the option being the difference between the cost of the debt instrument with or without the conversion option. The value of the option is likely to change in line with the value of the company’s shares - as these rise the more valuable the option becomes. Finally, the option can be settled at some future date.
As the host contract - the debt instrument and right to convert - is not a derivative, but the right to convert within the contract is, the convertible has an embedded derivative.
From the issuer’s perspective, the convertible in this case is a combination of a financial liability and an equity instrument (see CFM21250).
Embedded derivatives can also be found in contracts which are not themselves financial instruments, such as leases or sale or purchase contracts (see CFM25060).