Every debt instrument includes events of default. Certain of these may be embedded derivatives.
Recall that a financial instrument will fall into one of two types…a debt-host contract or an equity-host contract. Predictably, most loans will fall into the former. The embedded derivative issue arises when certain events of default are not debt-like in nature. FAS 133 considers these to have economic risks and characteristics that are not clearly and closely related to the debt host contract. Such events of default must be bifurcated and accounted for separately from the host contract.
Generally, to trigger this treatment such events must be themselves a trigger. That is, occurrence must be beyond the control of the company. The most common example is the requirement to deliver audited financial statements to the lender with failure to deliver causing payment of a financial penalty such as a default rate of interest (see Definition of a Derivative for further explanation). Delivery of audited statements does not affect the creditworthiness of the borrower and the borrower does not control issuance of the auditors’ report on such statements. This result has a potentially significant impact across a broad range of companies. It is rare that a loan agreement will not have such a requirement.
The valuation implications are equally problematic but the ‘out’ may be materiality. The lower the probability of the event occurring, the lower the value of the feature.