FASB: Embedded Derivatives: Identifying the Characteristics of a Debt Host Contract

Derivatives Implementation Group

Statement 133 Implementation Issue No. B19

Title: Embedded Derivatives: Identifying the Characteristics of a Debt Host Contract

Paragraph references:
12, 60

Date cleared by Board: June 28, 2000

QUESTION

How does an entity identify the characteristics of a debt host contract? Is the debt host contract for a hybrid bond embedded with a derivative required to be a fixed-rate, floating-rate, or zero-coupon bond? For example, for a bond indexed to the Standard and Poor's Composite Index of 500 Stocks (S&P 500) with coupons based on the S&P 500 yield, it isnt clear whether the host, plain-vanilla debt contract is a fixed-rate, floating-rate, or zero-coupon instrument.

BACKGROUND

Paragraph 12 of Statement 133 requires that an embedded derivative instrument be separated from the host contract and accounted for as a derivative instrument pursuant to the Statement if certain criteria are met. Paragraph 60 of Statement 133 provides guidance for determining whether the host contract is a debt or equity instrument. However, the embedded derivative provisions of Statement 133 do not provide explicit guidance regarding whether a debt host contract is required to be a fixed-rate, floating-rate, or zero-coupon bond.

RESPONSE

The characteristics of a debt host contract generally should be based on the stated or implied substantive terms of the hybrid instrument. Those terms may include a fixed-rate, floating-rate, zero-coupon, discount or premium, or some combination thereof.

In the absence of stated or implied terms, an entity may make its own determination of whether to account for the debt host as a fixed-rate, floating-rate, or zero-coupon bond. That determination requires the application of judgment, which is appropriate because the circumstances surrounding each hybrid instrument containing an embedded derivative may be different. That is, in the absence of stated or implied terms, it is appropriate to consider the features of the hybrid instrument, the issuer, and the market in which the instrument is issued, as well as other factors, in order to determine the characteristics of the debt host contract.

However, an entity may not express the characteristics of the debt host contract in an manner that would result in identifying an embedded derivative that is not already clearly present in a hybrid instrument. For example, it would be inappropriate to identify a floating-rate host contract and an interest rate swap component that has a comparable floating-rate leg in an embedded compound derivative, in lieu of identifying a fixed-rate host contract. Similarly, it would be inappropriate to identify a fixed-rate host contract and a fixed-to-floating interest rate swap component in an embedded compound derivative in lieu of identifying a floating-rate host contract.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.