Derivatives Implementation Group

Statement 133 Implementation Issue No. E2

QUESTION

Must the written option component and the purchased option component of a combination of options be based on the same underlying and have identical terms (such as number of units and maturity dates) to be considered a net purchased option or zero cost collar and therefore not subject to the effectiveness test in paragraphs 20(c) and 28(c)?

BACKGROUND

Statement 133 addresses when a combination of options (that is, a combination of a written option and a purchased option, whether in separate option contracts or embodied in a single contract) must be viewed as a written option subject to the effectiveness test in paragraph 20(c) for fair value hedges and in paragraph 28(c) for cash flow hedges. Subparagraph 20(c)(1) states:

     A combination of options (for example, an interest rate collar) entered into contemporaneously shall be considered a written option if either at inception or over the life of the contracts a net premium is received in cash or as a favorable rate or other term. (Thus, a collar can be designated as a hedging instrument in a fair value hedge without regard to the test in paragraph 20(c) unless a net premium is received.) Furthermore, a derivative instrument that results from combining a written option and any other non-option derivative shall be considered a written option.

Paragraph 28(c) effectively incorporates the requirements of subparagraph 20(c)(1) by a specific reference to that subparagraph.

RESPONSE

For a combination of options in which the strike price and the notional amount in both the written option component and the purchased option component remain constant over the life of the respective component, that combination of options would be considered a net purchased option or a zero cost collar (that is, considered not to be a net written option subject to the requirements of paragraphs 20(c) and 28(c)) provided all of the following four conditions are met:

1. No net premium is received.
2. The components of the combination of options are based on the same underlying.
3. The components of the combination of options have the same maturity date.
4. The notional amount of the written option component is not greater than the notional amount of the purchased option component.

If the combination of options does not meet all of those conditions, it is subject to the test in paragraph 20(c) for fair value hedges and in paragraph 28(c) for cash flow hedges. For example, under this guidance, a combination of options having different underlying indices, such as a collar containing a written floor based on three-month Treasury rates and a purchased cap based on three-month LIBOR, may not be considered a net purchased option or a zero cost collar even though those rates may be highly correlated.

The above response does not address a combination of options in which either the strike price or the notional amount in either the written option component or the purchased option component can fluctuate over the life of the respective component and whether that combination of options should be considered a net purchased option or a zero cost collar. Consequently, the above four conditions for concluding that a combination of options would be considered a net purchased option or a zero cost collar are not intended to apply to such options.

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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