Derivatives Implementation Group

Statement 133 Implementation Issue No. B22

QUESTION

In separating an option-based embedded derivative from the host contract under paragraph 12, must the terms of that option-based embedded derivative be determined so as to result in the derivative being at-the-money (that is, the strike price equals the price of the asset associated with the underlying, in which case the intrinsic value is zero) and, therefore, a fair value equal to the time value component?

BACKGROUND

Paragraph 12 of Statement 133 requires that an embedded derivative instrument be separated from the host contract and accounted for as a derivative instrument pursuant to the Statement if certain criteria are met. The embedded derivative provisions of Statement 133 do not provide explicit guidance regarding whether an embedded derivative must be assumed to have a fair value of zero (that is, be "at-the-money"). The conclusion in Statement 133 Implementation Issue No. B20, "Must the Terms of a Separated Non-Option Embedded Derivative Produce a Zero Fair Value at Inception?" indicates that in separating a non-option embedded derivative from the host contract under paragraph 12, the terms of that non-option embedded derivative should be determined in a manner that results in a fair value generally equal to zero at the inception of the hybrid instrument. For purposes of this Issue, assume that the hybrid instrument is not a derivative in its entirety.

RESPONSE

No, the terms of the option-based embedded derivative should not be adjusted to result in the derivative being at-the-money at the inception of the hybrid. In separating an option-based embedded derivative from the host contract under paragraph 12, the strike price of the embedded derivative should be based on the stated terms documented in the hybrid contract. As a result, the option-based embedded derivative at inception may have a strike price that does not equal the market price of the asset associated with the underlying.

There are substantive, fundamental differences between forward-based and option-based contracts. Adjusting the strike price of an option-based embedded derivative fundamentally alters the economics of the hybrid instrument, whereas adjusting the strike price of a forward-based embedded derivative does not necessarily fundamentally alter the economics of the hybrid instrument, as discussed in Implementation Issue B20. For example, if an option-based derivative is in-the-money, that intrinsic value amount does not represent a lending activity since the option may never be exercised (that is, it may expire out-of-the-money due to a change in the underlying) and, therefore, a cash flow may not occur by the end of the term. Conversely, the contractual terms of a forward contract are such that a cash flow will occur at maturity. Thus, if the terms of a forward result in a fair value other than zero, that amount effectively represents a borrowing (pursuant to the guidance in Implementation Issue B20). The foregoing fundamental distinctions warrant different guidance on accounting for option-based and non-option-based embedded derivatives.

The guidance in this Issue addresses the bifurcation of the option-based embedded derivative by a holder who has acquired the hybrid instrument from a third party either at inception or subsequent to inception of that hybrid instrument. The guidance also addresses the bifurcation of the option-based embedded derivative by the issuer when separate accounting for that embedded derivative is required.

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.