Derivatives and Embedded Derivatives: formula sheet

Key formulas

Definition test (all three must hold)

Derivative = Underlying-linked value + Little or no initial net investment + Settlement at a future date

If any one feature is missing, the contract is not a derivative under Ind AS 109.

Gain or loss on a forward purchase (long)

Gain/(loss) = (Spot or forward price at settlement − Contract price) × Quantity

The seller (short) has the opposite result. Use the notional quantity.

Payoff to option holder (call)

Payoff = Maximum of (Market price − Strike price, 0) × Quantity

Net result for the holder = Payoff − Premium paid. The writer's result is the opposite.

Payoff to option holder (put)

Payoff = Maximum of (Strike price − Market price, 0) × Quantity

Premium paid is a cost to the holder at inception.

Net settlement in a swap

Net amount = (Rate A − Rate B) × Notional amount × Period

Only the net difference is paid. The notional amount is usually not exchanged.

Host is a financial asset in scope of Ind AS 109

Do not separate. Classify the whole hybrid contract using the business model and SPPI tests.

Applies to the asset holder. Any embedded feature that is not SPPI usually pushes the whole asset to FVTPL.

Three conditions to separate (non-asset host)

Separate only if: (1) not closely related to host AND (2) meets derivative definition as a stand-alone instrument AND (3) hybrid not at FVTPL

All three must hold. Failing any one means no separation.

Accounting after separation

Embedded derivative at FVTPL; host under the applicable Ind AS; host initial carrying amount = hybrid amount − derivative fair value

The derivative is measured at fair value first. The host is the residual, so no day-one gain or loss arises from separation.

Fallback when derivative cannot be measured

If the embedded derivative cannot be measured separately, measure the entire hybrid contract at FVTPL (required)

This is mandatory, not a choice. Designating the whole hybrid at FVTPL is a separate, optional choice when separation would otherwise be required.

Multiple embedded derivatives

Treat multiple embedded derivatives in one hybrid as a single compound embedded derivative

Exception: derivatives in different risk exposures that can be readily separated and are independent of each other are accounted for separately.

Three conditions for separation

Separate if: (1) not closely related to host AND (2) separate instrument meets derivative definition AND (3) hybrid not at FVTPL

All three must hold. If any one fails, do not separate. Applies to hosts that are not assets within Ind AS 109 scope.

Financial asset host

Hybrid financial asset (Ind AS 109 scope) → no separation; classify whole contract

Use the business model and SPPI tests on the whole hybrid asset.

Accounting after separation

Embedded derivative → FVTPL; Host → under applicable Ind AS (e.g. amortised cost)

Host carrying amount on initial recognition = hybrid amount minus fair value of derivative (residual approach).

Initial allocation

Host initial amount = Hybrid initial amount − Fair value of embedded derivative

Derivative is valued first at fair value; the host gets the residual. Do not fix a value for the host and let the derivative be the balancing figure.

Fair value option alternative

Whole hybrid may be designated at FVTPL instead of separating (Ind AS 109 para 4.3.5)

Allowed for the entire hybrid contract, except where the embedded derivative does not significantly modify the cash flows or where separation is clearly prohibited (e.g. a prepayment option in a loan).

Three-condition separation test

Separate only if: (1) not closely related to host AND (2) stand-alone instrument would be a derivative AND (3) hybrid not at FVTPL

Applies to financial liability hosts and non-financial hosts. A financial asset host within scope is never split. The whole asset is classified under the SPPI test.

Put, call or prepayment option in a debt host

Closely related if exercise price ≈ amortised cost of the host at each exercise date, and the exercise price is not indexed to equity or commodity prices

A prepayment option is also closely related if the exercise price compensates the lender up to about the present value of lost interest for the remaining term. An option whose price is indexed to equity or commodity prices is not closely related.

Option to extend the term of debt

Not closely related unless there is a concurrent reset to the market rate of interest

Applies to an extension option or automatic extension provision in a debt host.

Indexed interest or principal

Equity-indexed, commodity-indexed or credit-linked feature in a debt host = not closely related

An equity conversion option is also not closely related to a debt host. For the issuer, equity-classified conversion rights fall under Ind AS 32.

Interest rate cap or floor

Closely related if the cap or floor is at or out of the money at issue, and not leveraged

At issue, a cap must be at or above the market rate and a floor at or below the market rate, so that neither is in the money. A leveraged cap or floor is not closely related.

Lease features

Closely related: inflation index of the entity's own economic environment (unleveraged), contingent rent on related sales, contingent rent on variable interest rates

Foreign currency in a lease or purchase contract is closely related if the currency is the functional currency of a substantial party, or is commonly used in that environment or in international trade for that item.

Multiple embedded derivatives

Treat as one compound derivative unless different risks AND readily separable AND independent

The same rule applies when you decide how many components to measure at FVTPL.

Measuring after separation

Non-option derivative: fair value nil at inception. Option-based: host = hybrid carrying amount − derivative fair value

For an option-based derivative, use the stated terms of the option and its stated fair value. The host is the residual. If you cannot measure the embedded derivative reliably, you may designate the whole hybrid at FVTPL.

Timing of assessment

Assess at the date the entity first becomes a party to the contract

Do not assess again because of market price, rate or credit changes.

Reassessment trigger (para B4.3.11)

Reassessment is prohibited unless the contract terms change and the cash flows that would otherwise be required are significantly modified. Then it is required.

Both parts are needed. The test compares the cash flows required under the contract before and after the change. A change in market conditions alone is never a trigger. For a financial liability, a substantial modification is treated as extinguishment and a new liability (para 3.3.2), not as a reassessment.

Separation conditions (all three)

Separate if: (1) economic characteristics and risks are not closely related to the host, (2) a separate instrument with the same terms meets the definition of a derivative, (3) the hybrid is not measured at FVTPL

If the host is a financial asset within Ind AS 109, skip this test and apply SPPI to the whole asset.

Whole-contract FVTPL option (para 4.3.5)

Contract with one or more embedded derivatives and a host that is not an asset within the scope of Ind AS 109: may designate the whole contract at FVTPL

Not available if the embedded derivative does not significantly modify the cash flows, or if it is clear with little analysis that separation is prohibited.

Accounting after separation

Derivative at FVTPL; host by applicable Ind AS

At initial recognition, the host's carrying amount is the hybrid's amount minus the derivative's fair value. On a later reassessment, Ind AS 109 gives no separate host-carrying-amount rule. Account for the host and the derivative from the reassessment date, with the derivative at fair value and the residual amount treated as the host.

Quick revision

• A derivative's value changes with a specified underlying variable such as an interest rate, price, exchange rate or index.
• A derivative needs no initial net investment, or one smaller than other contracts with similar response to market changes.
• A derivative is settled at a future date.
• A hybrid contract has a host and an embedded derivative; the embedded feature makes some cash flows vary like a standalone derivative.
• If the host is a financial asset within the scope of Ind AS 109, the whole hybrid is classified by the business model and contractual cash flow tests, with no separation. If the host is not such an asset (for example a financial liability or a lease or purchase contract), apply the separation conditions.
• Separate an embedded derivative only if all conditions are met: not closely related, a separate instrument would be a derivative, and the hybrid is not at fair value through profit or loss.
• A separated embedded derivative is measured at fair value through profit or loss; the host follows the applicable Ind AS.
• If the fair value of an embedded derivative cannot be measured reliably, the whole hybrid contract can be treated as at fair value through profit or loss.
• Closely related means the economic characteristics and risks of the feature are clearly linked to those of the host.
• For a hybrid contract whose host is not a financial asset within scope (for example a financial liability or a purchase contract), the assessment is made when the entity first becomes a party to the contract. Reassessment is prohibited unless the contract terms change so as to significantly modify the cash flows that would otherwise be required, or a financial asset is reclassified out of the fair value through profit or loss category.
• Always write answers as provision, facts and conclusion.

Common mistakes

• Saying a derivative needs zero initial investment. Fix: Write 'no or little initial net investment'. An option premium is a payment, yet the contract is still a derivative.
• Treating an outright purchase of shares as a derivative because the price moves. Fix: Check feature 2. Buying shares needs full investment and fails the test.
• Separating an embedded derivative from a financial asset host. Fix: Check the host first. For a financial asset within Ind AS 109, classify the whole contract using business model and SPPI tests.
• Treating the three conditions as alternatives. Fix: All three must be met. Always confirm the derivative definition and that the hybrid is not at FVTPL.
• Separating an embedded derivative from a hybrid financial asset. Fix: For a financial asset host within Ind AS 109 scope, classify the whole contract using business model and SPPI tests.
• Skipping the derivative definition test. Fix: Check that a separate instrument with the same terms would be a derivative. A feature that is not a derivative cannot be separated.
• Separating an embedded derivative from a financial asset host. Fix: Check the host first. A financial asset in scope is classified as a whole under the SPPI test. Separation is only for liabilities and non-financial hosts.
• Calling every call or put option on debt a derivative to be separated. Fix: Compare the exercise price with amortised cost at each exercise date. If they are about equal and the price is not indexed to equity or commodity prices, the option is closely related and stays in the host.
• Reassessing every year-end because interest rates or prices moved. Fix: Remember that the assessment is once, at inception. Market movements change the fair value of a separated derivative but never trigger a new separation test.
• Saying any amendment to the contract triggers reassessment. Fix: Both parts are needed: a change in terms and a significant modification of cash flows. A minor administrative amendment does not qualify.

Exam tips

• In written answers, write the three characteristics as separate lines and apply each to the facts. This earns step marks.
• In case MCQs, look for how much was paid on day one and when settlement occurs. These decide the answer quickly.
• Learn one line each for forward, future, option and swap, including the forward vs futures difference, as it is frequently asked.
• If a question asks about accounting, add that derivatives are generally measured at fair value through profit or loss unless designated in a hedge.
• Start every answer by naming the host. Many marks depend on that single step.
• In a written answer, list the three conditions in order and apply each one to the facts.
• For financial asset hosts, use the words whole contract and SPPI. Do not write separate.
• Show the journal entry and the residual host calculation. The correct order is derivative first, host as residual.