FASB Embedded Derivatives Must the Terms of a Separated Non-Option Embedded Derivative Produce a Zero Fair Value at Inception?

FASB: Embedded Derivatives: Must the Terms of a Separated Non-Option Embedded Derivative Produce a Zero Fair Value at Inception?

Derivatives Implementation Group

Statement 133 Implementation Issue No. B20

Title:

Embedded Derivatives: Must the Terms of a Separated Non-Option Embedded Derivative Produce a Zero Fair Value at Inception?

Paragraph reference: 12
Date cleared by Board: June 28, 2000
Date revision posted to website: March 14, 2006
Affected by: FASB Statement No. 155, Accounting for Certain Hybrid Financial Instruments
(Revised February 16, 2006)

QUESTION

In separating a non-option embedded derivative from the host contract under paragraph 12, must the terms of that non-option embedded derivative be determined so as to result in the derivative having a fair value of zero (that is, be "at-the-market") at the inception of the hybrid instrument? This question assumes that the non-option embedded derivative is a plain-vanilla forward contract with symmetrical risk exposure and that the hybrid instrument was newly entered into by the parties to the contract. Specifically, should the separation of the illustrative hybrid instruments below (that is, the structured notes) into embedded derivatives and host debt instruments (1) be the same for all five terms described for the structured note (because they are merely different descriptions of the same ultimate cash flows) or (b) be different (either mandatorily or permissively) in order to reflect the terms of the structured note?

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. (Note that Statement 155 was issued in February 2006 and allows for a fair value election for hybrid financial instruments that otherwise would require bifurcation. Hybrid financial instruments that are elected to be accounted for in their entirety at fair value cannot be used as a hedging instrument in a Statement 133 hedging relationship.) The embedded derivative provisions of Statement 133 do not provide explicit guidance regarding whether an embedded derivative must be assumed to have a fair value of zero at the inception of the hybrid instrument. For purposes of this Issue, assume that the hybrid instrument is not a derivative in its entirety.

Example Hybrid Instruments—Embedded Forward Contracts

Company A plans to advance Company X $900 for 1 year at a 6 percent interest rate and concurrently enter into an equity-based derivative in which it will receive any increase or pay any decrease in the current market price ($200) of XYZ Corporation's common stock. Those two transactions (that is, the loan and the derivative) can be bundled in a structured note that could have almost an infinite variety of terms. The following presents five possible contractual terms for the structured note that would be purchased by Company A for $900:

  1. Note 1: Company A is entitled to receive at the end of 1 year $954 plus any excess (or minus any shortfall) of the current per share market price of XYZ Corporation's common stock over (or under) $200.

  2. Note 2: Company A is entitled to receive at the end of 1 year $955 plus any excess (or minus any shortfall) of the current per share market price of XYZ Corporation's common stock over (or under) $201.

  3. Note 3: Company A is entitled to receive at the end of 1 year $755 plus any excess (or minus any shortfall) of the current per share market price of XYZ Corporation's common stock over (or under) $1.

  4. Note 4: Company A is entitled to receive at the end of 1 year $1,054 plus any excess (or minus any shortfall) of the current per share market price of XYZ Corporation's common stock over (or under) $300.

  5. Note 5: Company A is entitled to receive at the end of 1 year $1,060 plus any excess (or minus any shortfall) of the current per share market price of XYZ Corporation's common stock over (or under) $306.

All of the above five terms of a structured note will provide the same cash flows, given a specified market price of XYZ Corporation's common stock. If the market price of XYZ Corporation's common stock at the end of 1 year is still $200, Company A will receive $954 under all 5 note terms. If the market price of XYZ Corporation's common stock at the end of 1 year increases to $306, Company A will receive $1,060 under all 5 note terms.

For simplicity in constructing this example, it is assumed that an equity-based cash-settled forward contract with a strike price equal to the stock's current market price has a zero fair value. In many circumstances, a zero-value forward contract can have a strike price greater or less than the stock's current market price.

RESPONSE

Yes. In separating a non-option embedded derivative from the host contract under paragraph 12, the terms of that non-option embedded derivative should be determined in a manner that results in its fair value generally being equal to zero at the inception of the hybrid instrument. Since a loan and a derivative can be bundled in a structured note that could have almost an infinite variety of stated terms, it is inappropriate to necessarily attribute significance to every one of the note's stated terms in determining the terms of the non-option embedded derivative. If a non-option embedded derivative has stated terms that are off-market at inception, that amount should be quantified and allocated to the host contract since it effectively represents a borrowing. (This Issue does not address the bifurcation of the embedded derivative by a holder who has acquired the hybrid instrument from a third party subsequent to the inception of that hybrid instrument.)

The non-option embedded derivative should contain a notional amount and an underlying consistent with the terms of the hybrid instrument. Artificial terms should not be created to introduce leverage, asymmetry, or some other risk exposure not already present in the hybrid instrument. Generally, the appropriate terms for the non-option embedded derivative will be readily apparent. Often, simply adjusting the referenced forward price (pursuant to documented legal terms) to be at-the-market for the purpose of separately accounting for the embedded derivative will result in that non-option embedded derivative having a fair value of zero at inception of the hybrid instrument.

The differences in the terms for the above five notes are totally arbitrary because those differences have no impact on the ultimate cash flows under the structured note; thus, those differences are nonsubstantive and should have no influence on how the terms of an embedded derivative are identified. Therefore, the separation of the hybrid instrument into an embedded derivative and a host debt instrument should be the same for all five terms described above for the structured note (because they are merely different descriptions of the same ultimate cash flows). That bifurcation would generally result in the structured note being accounted for as a debt host contract with an initial carrying amount of $900 and a fixed annual rate of interest of 6 percent and an embedded forward contract with a $200 forward price, which results in an initial fair value of zero. Instead, if the five notes were bifurcated based on all their contractual terms, such bifurcation would be the equivalent of simply marking an arbitrary portion of a debt instrument to market based on nonsubstantive arbitrary differences in those contractual terms—an inappropriate outcome.

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.