Derivatives Implementation Group

Statement 133 Implementation Issue No. G22

QUESTIONS

Can the complex option described in the example in the background section be designated as a hedging instrument and used in the following cash flow hedging relationships:

1. To hedge the variability in the difference between interest payments and sales proceeds on oil?

    

2. To hedge the variability in interest cash flows attributable to changes in LIBOR above 7 percent?

    

3. To hedge the variability in proceeds from the forecasted sale of oil?

BACKGROUND

Company A enters into a complex option contract with multiple underlyings for which no net premium is received. The payoffs under the contract are nontraditional. Company A wishes to designate the option in a cash flow hedging relationship.

For example, Company A is an oil producer with five-year floating-rate debt (indexed to three-month LIBOR) and is concerned that an environment of falling oil prices and rising interest rates could affect its ability to meet increasing interest payments on the floating-rate debt. To limit its exposure, Company A enters into a five-year oil-linked interest rate cap with a notional amount equal to the principal amount of Company A's three-month LIBOR-based floating-rate debt. The oil-linked interest rate cap (a complex option) has the following terms: if (1) 3-month LIBOR is greater than 7 percent and (2) the price of oil is less than $25 per barrel, Company A receives payments under the cap equal to the increased interest payments (that is, for floating-rate amounts above 7 percent) due on their floating-rate debt. However, if the daily price of oil goes above $25 per barrel at any time during a quarter, the option is knocked out for only that specific quarter. The option's knock-out feature is reset each quarter such that the interest rate coverage is knocked out for a specific quarter only if the daily price of oil goes above $25 per barrel at any time during that specific quarter. Thus, the option limits Company A's exposure to increases in interest rates for all quarters in which oil prices remain under $25 per barrel throughout the quarter.

RESPONSES

Question 1

No. The oil-linked interest rate cap purchased by Company A is attempting to hedge Company A's exposure to variability in the net cash flows related to certain revenue inflows and certain expense outflows. In the example, Company A wishes to reduce the risk that an increase in cash outflows due to increases in interest rates will occur without a concurrent increase in cash inflows due to increases in the price of oil per barrel. Those are separate and dissimilar risks that Company A wishes to hedge with a single derivative.

Paragraph 29(a) states, "If the hedged transaction is a group of individual transactions, those individual transactions must share the same risk exposure for which they are designated as being hedged." Thus, the hedged forecasted transaction cannot be a group of oil sales inflows and interest payment outflows. Statement 133 was not structured to permit hedge accounting for strategies involving hedges of a spread between revenues and expenses as Company A is attempting to accomplish.

Question 1

Generally, no because Company A could not simply define its hedged risk as the risk of changes in cash flows attributable to changes in the three-month LIBOR rate for only those periods when the price of oil per barrel is below a specified dollar amount. Paragraphs 29(g) and 29(h) indicate the risks that an entity may designate as the hedged risk. When hedging any of these risks, the hedging relationship must be expected to be highly effective in achieving offsetting cash flows attributable to the hedge risk.

If Company A wanted to designate the oil-linked interest rate cap as a cash flow hedge of the variability in interest payments on the LIBOR-based floating-rate debt due to changes in interest rates above the contractually specified 7 percent rate in the interest rate cap, Company A would be required to assess effectiveness whenever interest rates were above that 7 percent rate. Because the cap also has an underlying related to oil prices, there could be times when interest rates will be above the contractually specified interest rate in the cap but the complex option will not result in any cash flows because the selling price of oil is not below the contractually specified price per barrel ($25). In other words, the complex option will be out of the money but Company A will be required to assess the option's effectiveness in offsetting the increase in interest payments for the effect of the excess of 3-month LIBOR over 7 percent.

Generally, it would be unlikely that Company A could conclude that the oil-linked interest rate cap is expected to be highly effective in achieving offsetting cash flows if it is reasonably possible that the oil-linked option will knock out the cash inflows from the derivative. In its assessment of the effectiveness of the hedge of the interest payments on the floating-rate debt, Company A must consider the likelihood that the interest-rate protection from the oil-linked interest rate cap may be knocked out due to oil prices exceeding the contractually specified amount per barrel and it may not exclude from its assessment of effectiveness those periods when the interest rate protection is knocked out. For those quarters when the cap is knocked out, there are no cash flows from the cap to be used to offset the change in the cash flows on the hedged forecasted transaction.

In the unlikely event that Company A was able to conclude that the relationship was expected to be highly effective (because the complex option was expected to be highly effective for all changes in the three-month LIBOR rate above the contractually specified rate due to the remoteness that the price of oil per barrel would not be below the contractually specified amount over the contractual life of the debt), the complex option could be used as the hedging derivative.

Question 1

No. If Company A wanted to designate the oil-linked interest rate cap as a cash flow hedge of the risk of overall changes in the sales proceeds from the forecasted sale of oil below the contractually specified price per barrel in the interest rate cap, the hedging relationship would fail to qualify under paragraph 28(b) because the cash inflows from the oil-linked interest rate cap are calculated based on the debt's principal amount and the excess of 3-month LIBOR over 7 percent. Because the cash inflows from the oil-linked interest rate cap are unrelated to the proceeds from oil sales, Company A could not expect the proposed hedging relationship to be highly effective at achieving offsetting cash flows.

EFFECTIVE DATE

The effective date of the implementation guidance in this Issue for each reporting entity is the first day of its first fiscal quarter beginning after October 10, 2001, the date that the Board-cleared guidance was posted on the FASB website.

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.