embedded derivative

Definition

A component of a hybrid security that is embedded in a non-derivative instrument. An embedded derivative can modify the cash flows of the host contract because the derivative can be related to an exchange rate, commodity price or some other variable which frequently changes. For example, a Canadian company might enter into a sales contract with a Chinese company, creating a host contract. If the contract is denominated in a foreign currency, such as the U.S. dollar, an embedded foreign currency derivative is created. According to the International Financial Reporting Standards (IFRS), the embedded derivative has to be separated from the host contract and accounted for separately unless the economic and risk characteristics of both the embedded derivative and host contract are closely related.

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The embedded derivative was a really interesting thing to me and it made me wonder what was going on and how to work with it.

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Many hedge funds as well as traditional investment firms and companies will utilize an embedded derivative instrument to create profit.

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embedded derivative A component of a hybrid security that is embedded in a non-derivative instrument. An embedded derivative can modify the cash flows of the host contract because the derivative can be related to an exchange rate, commodity price or some other variable which frequently changes.

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