Derivatives Implementation Group

Statement 133 Implementation Issue No. B3

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.