A company issues 5-year bonds, carrying a fixed coupon of 3%. At
maturity, they redeem at a premium linked to any growth in the
FT-SE 100 index over the 5 years. The holder receives back their
original capital if the index has fallen.
The bonds constitute debt contracts into which are embedded
option contracts linked to the FT- SE 100. Because the economic
characteristics of equity investment differ from those of the host
contract, the derivatives are not closely related and must be
separated.
A company issues loan notes with a two-year maturity and an
interest coupon of 6%. After two years, the issuing company has the
option to extend the term of the debt for a further two years. The
interest coupon would remain at 6%.
The option to extend the term of the debt is an embedded
derivative, whose underlying subject matter is interest rates. The
IASB regards the term extension as not being closely related to the
host contract where the interest rate does not reset to a market
rate.
A UK company enters into a contract to provide services to
another UK company. The purchaser of the services has the option of
settling the contract in either sterling or Swiss francs. The Swiss
franc is not the functional currency of either company.
The host contract here is a contract for services, which
contains an embedded currency option. The currency option is not
closely related to the host contract, and therefore requires to be
separated.
