Derivatives Implementation Group
Statement 133 Implementation Issue No. B3
| Title: |
Embedded Derivatives:
Investor's Accounting for a Put or Call Option Attached to a Debt
Instrument Contemporaneously with or Subsequent to Its
Issuance |
| Paragraph
references: |
61(d) |
| Date cleared by
Board: |
March 31, 1999 |
| Affected by: |
FASB Statement No. 138,
Accounting for Certain Derivative Instruments and Certain
Hedging Activities
(Revised September 25, 2000) |
QUESTION
Should an investor (creditor) account separately for
a put or call option that is added to a debt instrument by a third
party contemporaneously with or subsequent to the issuance of the
debt instrument?
BACKGROUND
Example 1 presents a transaction that involves the
addition of a call option contemporaneously with or subsequent to
the issuance of debt. Example 2 presents a group of transactions
with a similar overall effect.
Example 1
Company X issues 15-year puttable bonds to an Investment Banker for
$102. The put option may be exercised at the end of five years.
Contemporaneously, the Investment Banker sells the bonds with an
attached call option to Investor A for $100. (The call option is a
written option from the perspective of Investor A and a purchased
option from the perspective of the Investment Banker.) The
Investment Banker also sells to Investor B for $3 the call option
purchased from Investor A on those bonds. The call option has an
exercise date that is the same as the exercise date on the embedded
put option. At the end of five years, if interest rates increase,
Investor A would presumably put the bonds back to Company X, the
issuer. If interest rates decrease, Investor B would presumably
call the bonds from Investor A.
Example 2
Company Y issues 15-year puttable bonds to Investor A for $102. The
put option may be exercised at the end of five years.
Contemporaneously, Company Y purchases a transferable call option
on the bonds from Investor A for $2. Company Y immediately sells
that call option to Investor B for $3. The call option has an
exercise date that is the same as the exercise date of the embedded
put option. At the end of five years, if rates increase, Investor A
would presumably put the bonds back to Company Y, the issuer. If
rates decrease, Investor B would presumably call the bonds from
Investor A.
RESPONSE
Yes. A put or call option that is added to a debt
instrument by a third party contemporaneously with or subsequent to
the issuance of the debt instrument should be separately accounted
for as a derivative under Statement 133 by the investor (that is,
by the creditor); it must be reported at fair value with changes in
value recognized currently in earnings unless designated in a
qualifying hedging relationship as a hedging instrument. As a
result, in Example 1 above, the call option that is attached by the
Investment Banker is a separate derivative from the perspective of
Investor A. Similarly, the call option described in Example 2 is a
separate freestanding derivative that also must be reported at fair
value with changes in value recognized currently in earnings unless
designated as a hedging instrument.
An option that is added or attached to an existing
debt instrument by another party results in the investor having
different counterparties for the option and the debt instrument
and, thus, the option should not be considered an embedded
derivative. The notion of an embedded derivative in a
hybrid instrument refers to provisions incorporated into a single
contract, and not to provisions in separate contracts between
different counterparties.
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.
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