A hedge with FX or commodity options as the hedging instrument could be treated as either a fair value or cash flow hedge, depending on the risk being hedged. The exposure under a fair value and cash flow hedge is different in that a fair value risk exists if fair value can change for either a recognized asset/liability or an unrecognized firm commitment, and a cash flow risk exists if amounts of future cash flows that could affect earnings can change.
For example, if the hedged item is an already recognized receivable denominated in a foreign currency, it would be a fair value hedge. On the contrary, if the hedged risk is exposure to variability in expected future cash flows attributable to a particular FX rate or commodity price, the hedge would be classified as a cash flow hedge. The accounting treatment for fair value and cash flow hedge is different. In practice there are more cash flow hedges with options and that is what the remainder of this technical overview will focus on for further discussions.
A critical requirement before one can apply hedge accounting is the analysis that supports the assessment of hedge effectiveness. For cash flow hedges usually the Hypothetical Derivative Method is used, where effectiveness is calculated by comparing the change in the hedging instrument and the change in a "perfectly effective" hypothetical derivative. FAS 133 has specified the conditions the hypothetical derivative should meet as follows:
- The critical terms of the hypothetical (such as notional amount, underlying and maturity date, etc.) completely match the related terms of the hedged forecasted transaction
- The strike of the hedging option matches the specified level beyond (or within) which the entity's exposure is being hedged
- The hypothetical's inflows (outflows) at its maturity completely offset the change in the hedged transaction's cash flows for the risk being hedged; and
- The hypothetical can be exercised only at a single date
When valuing an option, it is convenient to break it down into intrinsic value and time value. The intrinsic value of an FX or commodity option can be calculated using either the spot rate or the forward rate, and the time value is just any value of the option other than its intrinsic value.
Example of Euro/USD Option Intrinsic and Time Value
For cash flow hedges with options, US GAAP provides more flexibility than IFRS. IFRS requires the intrinsic value to be separated from the time value of an option, and only the intrinsic value is included in the hedge relationship. This requirement means the effectiveness is assessed based on changes in the option's intrinsic value only (either spot or forward intrinsic value can be used). On the other hand, US GAAP allows an entity the flexibility to choose between assessing effectiveness based on total changes in the option's fair value (including time value), and assessing effectiveness based on changes in intrinsic value only (excluding time value)
As a result of different values the assessment of effectiveness can be based on, the financial statements would look different. When time value is excluded from the hedge relationship, the assessment of effectiveness is based on changes in intrinsic value only, the change in time value would be recorded in the income statement and result in increased earnings volatility.
Both IFRS and US GAAP permit designating a purchased option or a combination of purchased options, as hedging instruments. A written option cannot be a hedging instrument, unless it is designated as an offset of a purchased option and the following conditions are met:
- No net premium is received either at inception or over the life of the options
- Except for the strike prices, the critical terms and conditions of the written option and the purchased option are the same (underlying, currency denomination, maturity, etc)
- Notional amount of the written option is not greater than notional amount of the purchased option
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