Financial Reporting · Derivatives and Embedded Derivatives

Examples of Closely and Not Closely Related Embedded Derivatives (Ind AS 109)

Updated 5 October 2026 · Fact-checked

An embedded derivative is a component of a hybrid contract that changes its cash flows like a stand-alone derivative. You separate it from a financial liability or non-financial host only if its risks are not closely related to the host, a stand-alone version would be a derivative, and the hybrid is not at FVTPL. Test each feature against the examples.

Understand Examples of Closely and Not Closely Related Derivatives

A hybrid contract has a host and one or more embedded derivatives. Think of a debenture whose redemption amount rises with the Nifty. The debenture is the host. The Nifty-linked payout is the embedded derivative.

Before you test any feature, check the host. If the host is a financial asset within the scope of Ind AS 109, you do not separate anything. You classify the whole asset by the business model and SPPI test. Separation applies when the host is a financial liability or a non-financial contract such as a lease or a purchase contract.

For those hosts, you separate the embedded derivative only if all three conditions hold. First, its economic characteristics and risks are not closely related to the host. Second, a separate instrument with the same terms would meet the definition of a derivative. Third, the hybrid is not measured at fair value through profit or loss. If all three hold, the embedded derivative goes to FVTPL and the host follows its normal standard.

The real exam skill is the first condition. The application guidance in Appendix B gives typical examples. Debt with a put or call at about amortised cost is closely related, provided the exercise price is not indexed to equity or commodity prices. Equity-indexed, commodity-indexed and credit-linked features are not closely related. Inflation in a lease and a currency that is commonly used are closely related. Learn the pattern, not each example in isolation.

When a contract has several embedded derivatives, they are normally treated as one compound embedded derivative. They are accounted for separately only if they relate to different risk exposures and are readily separable and independent of each other.

Key rules to remember

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.

How to solve Examples of Closely and Not Closely Related Derivatives questions

Use this order for any question on closely related or not closely related embedded derivatives.

1Identify the host and the feature. Say who is the holder and who is the issuer.
2Check whether the host is a financial asset in scope of Ind AS 109. If yes, do not separate. Classify the whole contract by business model and SPPI.
3If the hybrid is already at FVTPL, stop. No separation is needed.
4Match the feature to the standard pattern: option on debt, indexation, inflation, currency, cap or floor, credit link, term extension.
5Apply the exact condition. For example, compare the exercise price with amortised cost on each exercise date, or check whether the currency is a party's functional currency.
6Conclude in one line: closely related (no separation) or not closely related (separate at FVTPL).
7If separating, say how. Non-option derivative has fair value nil at inception. For an option, the host is the residual.
8If there are several features, decide whether they form one compound derivative or are separate.

Quickest way: Four-question shortcut

When to use it: Use this for short MCQs and for the first line of a written answer, when you have under three minutes.

Is the host a financial asset? If yes, answer: no separation, whole instrument under SPPI.
Is the feature a debt option? Compare the exercise price with amortised cost.
Is the feature an index? Equity, commodity and credit are out. Inflation and sales-linked rent in a lease are in.
Is it currency? Look for the functional currency of a party or a commonly used currency. If neither, it is not closely related.

Common mistakes in Examples of Closely and Not Closely Related Derivatives

Separating an embedded derivative from a financial asset host.
Students remember the three-condition test and apply it to every hybrid.
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.
Options look like derivatives, so students stop thinking.
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.
Treating all inflation-linked payments as closely related.
Students over-generalise from the lease example.
Fix: State the conditions. The index must relate to inflation in the entity's own economic environment and must not be leveraged. Use it as stated for leases, not for any contract.
Ignoring who the parties are in a foreign currency contract.
Students look only at the currency and not at the functional currencies of the parties.
Fix: Ask whether the currency is the functional currency of any substantial party, or commonly used for that item in international trade or locally. Only then is it closely related.
Accounting for each feature separately when several exist.
Students assume one feature means one derivative.
Fix: Treat multiple features as one compound embedded derivative unless they relate to different risks and are readily separable and independent.
Giving a fair value to a separated non-option derivative at inception.
Students value every derivative at a market price.
Fix: Set the terms so that a non-option embedded derivative has fair value nil at inception. For option-based derivatives, use the stated terms and fair value of the option, and give the host the residual amount.

Worked examples

Example 1

Entity P has INR as its functional currency and issues three separate series of debentures, each ₹10 crore at par, with no issue costs. Series A: P may redeem at par plus accrued interest at the end of year 3. Series B: redemption at the end of year 5 is ₹10 crore plus 50% of any rise in the Nifty 50 over the period. Series C: floating rate linked to a benchmark with a floor of 7% when the market rate at issue is 8%, not leveraged. Decide whether each feature must be separated.

Show the solution

The hosts are financial liabilities, so the separation test applies. None of the hybrids is at FVTPL.
Series A: the call is a debt option. The debentures were issued at par with no costs, so amortised cost at the end of year 3 is ₹10 crore plus accrued interest. The exercise price equals amortised cost, so the call is closely related.
Series B: the redemption amount depends on an equity index. An equity-indexed principal is not closely related to a debt host. A stand-alone contract with the same terms would be a derivative. So it must be separated and measured at FVTPL.
Series C: the floor of 7% is below the market rate of 8% at issue, so it is out of the money at issue, and it is not leveraged. The floor is closely related. No separation.
For Series B, the host debenture is accounted for at amortised cost and the equity-linked payout is carried at fair value through profit or loss.

Answer: Series A and Series C: closely related, no separation. Series B: the Nifty-linked redemption is not closely related and must be separated and measured at FVTPL.

Example 2

Entity Q has INR as its functional currency and issues ₹50 crore of 6% debentures at par. At the end of year 5, redemption is ₹50 crore plus 40% of any rise in the Sensex, subject to a minimum of ₹50 crore. Q also has the right to redeem early at the end of year 3 at ₹50 crore plus 40% of any rise in the Sensex up to that date, subject to a minimum of ₹50 crore. So the year-3 call price is determined by the Sensex gain, and the call is also equity-linked. At issue, the fair value of the combined equity-linked features is ₹6 crore. Explain the accounting.

Show the solution

The host is a financial liability, and the hybrid is not at FVTPL, so test for separation.
The Sensex-linked payout at year 5 is equity-indexed principal. It is not closely related to a debt host.
The year-3 call price is also set by the Sensex gain, so the call is equity-linked and not at amortised cost. It is not closely related either. Both features change the redemption amount for the same equity risk and are not independent. So treat them as one compound embedded derivative, not two.
The compound derivative is option-based. Do not assume a nil fair value. The host is the residual: ₹50 crore − ₹6 crore = ₹44 crore.
At initial recognition, record the embedded derivative at ₹6 crore at FVTPL and the host liability at ₹44 crore at amortised cost.
The host has no embedded call or equity-linked payout, because those sit in the derivative. Its cash flows therefore run to year 5: the 6% coupon of ₹3 crore a year plus ₹50 crore at the end of year 5. The effective interest rate is the rate that discounts these cash flows to the ₹44 crore carrying amount. At 9% the present value is about ₹44.17 crore and at 9.1% it is about ₹43.99 crore, so the rate is about 9.1%. It is higher than the 6% coupon because the ₹6 crore discount is accreted to profit or loss as finance cost over the term.
Q then remeasures the derivative to fair value at each reporting date, with changes in profit or loss.

Answer: Separate one compound embedded derivative of ₹6 crore at FVTPL. The host debenture is ₹44 crore at amortised cost. Its effective interest rate, computed on cash flows of ₹3 crore a year plus ₹50 crore at year 5 against ₹44 crore, is about 9.1%.

Exam tips

Write the classification word first: closely related or not closely related. Then give the reason in one line. Examiners award marks for the conclusion and the condition.
Always state the host. Many marks are lost because students skip the check that a financial asset host is not split.
For debt options, quote the comparison: exercise price against amortised cost at each exercise date. Give a number if the question supplies one.
In foreign currency cases, list the functional currency of each party before you answer.
In case-scenario MCQs, read the party carefully: holder or issuer, lessee or lessor. The answer often changes with the perspective.

Practice questions from Derivatives and Embedded Derivatives

Examples of Closely and Not Closely Related Derivatives: frequently asked questions

Is a put or call option in a debenture always an embedded derivative to be separated?

No. If the exercise price is about equal to the amortised cost of the host at each exercise date, the option is closely related and is not separated. A prepayment option that only compensates the lender for lost interest is also closely related. If the price is linked to an equity index or is otherwise off amortised cost, it is not closely related.

Are inflation-linked rentals in a lease closely related?

Yes, if the index relates to inflation in the entity's own economic environment and the feature is not leveraged. Rent based on related sales and rent based on variable interest rates are also closely related. A lease feature linked to something else needs a separate check.

Do I separate an embedded derivative from a financial asset?

No, not when the host is a financial asset within the scope of Ind AS 109. You classify the entire hybrid asset by the business model and SPPI test. The separation rules apply to financial liabilities and non-financial hosts.

What if a contract has more than one embedded derivative?

Treat them as a single compound embedded derivative. Account for them separately only if they relate to different risk exposures and are readily separable and independent of each other.