You’ll recall from yesterday’s post that there are three criteria to the accounting definition of a derivative:
a) There are i) one of more ‘underlyings’ and ii) one or more ‘notionals’ or payment provisions, or both;
b) There is no initial investment or an investment that is smaller than that normally expected of a contract that responds to market changes in a similar manner (i.e., delivers net gains and losses);
c) The contract can be net settled under the contract terms (i.e., the party in the net loss position ‘pays’ the party in the net gain position), through a market mechanism (e.g., the contract trades on an exchanged) or by delivery of a derivative or delivery of an asset that is readily convertible to cash (e.g., publicly traded stock).
Yesterday I covered the first criteria. Today I’ll look at the second.
The Accounting Standards Codification (ASC) definition of a derivative states that a derivative does not require an initial investment that is equal to the notional amount or that is determined by applying the notional amount to the underlying. Most derivative contracts require no investment at all, or require an initial investment that is less than that required to purchase asset or incur the liability related to the underlying to the contract. A warrant, for example, would not be purchased for the price a the underlying shares of stock. In this case, if the initial investment in the warrant is less than the underlying shares by more than a nominal amount (less than 90 – 95% in practice) after adjusting for the time value of money, then ASC 815-10-15-96 is met.
This evaluation is not usually difficult in the context of a single, freestanding instrument where you can look at the initial investment and evaluate that relative to the value of the underlying. The analysis becomes more difficult when there are a number of instruments involved in a single transaction, in which case you will need to evaluate the portion of proceeds from the transaction allocable to the instrument your are evaluating. So, in the case of a capital raise involving debt and a detachable warrant, the initial investment in the warrant is the amount of the investment proceeds allocable to the warrant (based on relative fair value). The allocated proceeds should then be compared to the value of the underlying stock into which the warrant is exercisable to determine if it is less by more than a nominal amount.
Another example is an interest rate swap contract which, depending on its terms, may have no value at inception or may have one party paying the other party an amount equal to the fair value of the contract at closing. Whatever the amount paid should be compared to the swap notional amount to determine if the initial investment is less by more than a notional amount.
The point in all of this is that a derivative contract typically exposes a party to the contract to the same (or similar) fluctuations as if the party had invested in an asset or incurred a liability related the underlying. The stock purchase warrant above, as adjusted for time value, would be priced less than the the underlying stock yet expose the investor to similar market fluctuations in risk and value. Same applies to the interest rate swap where the investor would be exposed to fair value fluctuations from changes in variable leg of the swap relative to the fixed leg as if the investor actually owned a debt instrument with a principal amount equal to the notional.
An embedded feature would be evaluated under this same criteria. The initial investment in the embedded feature is simply the amount of proceeds allocable to the feature. This will likely always be less than the proceeds allocable to the entire instrument in which the feature is embedded. So, an embedded conversion option in a convertible debt instrument would have allocable proceeds equal to the fair value of the option (usually a Black-Scholes option model calculation, but not always), and this amount would be less than the price of purchasing the underlying shares of stock which would, of course, provide the same risk and return as the option.