Derivatives Implementation Group

Statement 133 Implementation Issue No. F7

QUESTIONS

The following questions involve the use of collar-based hedging instruments in fair value hedge transactions:

1. In applying paragraph 20(c), does an entity have the flexibility to exclude the time value of the hedging written option (or net written option) and consider only the change in its intrinsic value in measuring the potential gain or loss on the combination of the written option (or net written option) and the hedged item?

    

2. Must the special written-option test in paragraph 20(c) be applied both at inception and throughout the entire term of the hedging relationship?

BACKGROUND

An entity enters into an equity price collar with an investment bank to hedge the fair value exposure of an equity security that it holds as an available-for-sale security. That collar is indexed to the price of the equity security held and consists of a purchased put with the strike price equal to $40 per share (whereby the holder can put the equity security to the investment bank for $40 per share) and a written call with the strike price equal to $60 per share (whereby the investment bank can call the equity security from the holder for $60 per share). The collar has the effect of insulating the equity security holder from any losses caused by equity price decreases below $40 per share, but the holder must sacrifice any unrealized gains caused by equity price increases above $60 per share. The hedged equity security has a fair value of $50 per share at inception of the collar. If the underlying increases by 50 percent to $75, the intrinsic value of the collar will decrease from zero to a loss of $15 per share ($75 - $60). If the underlying decreases by 50 percent to $25, the intrinsic value of the collar will increase from zero to a gain of $15 per share ($40 - $25). Despite the symmetrical changes in the intrinsic value of the collar in response to an upward and a downward change in the equity index by the same percentage, the market views the likelihood that the underlying equity price will increase as greater than the likelihood that it will decrease. Accordingly, the investment bank is willing to pay a premium to the equity security holder.

The following table shows the calculation of the gain and loss for a market price move of 50 percent. (The special written-option test in paragraph 20(c) requires consideration of all possible percentage favorable changes in the underlying (from zero percent to 100 percent) and all possible percentage unfavorable changes in the underlying.)

(The time values of the options were selected to emphasize importance of the Issue.)

Paragraph 20(c) discusses the use of written options in fair value hedges and states the following:

   If a written option is designated as hedging a recognized asset or liability, the combination of the hedged item and the written option provides at least as much potential for gains as a result of a favorable change in the fair value of the combined instruments as exposure to losses from an unfavorable change in their combined fair value. That test is met if all possible percentage favorable changes in the underlying (from zero percent to 100 percent) would provide at least as much gain as the loss that would be incurred from an unfavorable change in the underlying of the same percentage. [Footnote reference omitted.]

Subparagraph 20(c)(1) states in part the following:

   A combination of options...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.)

RESPONSES

Question 1

Yes. The time value of the written option (or net written option) may be excluded from the special written-option test in paragraph 20(c) provided that, in defining how hedge effectiveness will be assessed, the entity specifies that it will base that assessment on only changes in the option's intrinsic value. Therefore, the change in the time value of the options would be excluded from the assessment of hedge effectiveness in accordance with paragraph 63(a). Accordingly, when applying the special written-option test to determine whether there is symmetry of the gain and loss potential of the combined hedged position for all possible percentage changes in the underlying, an entity is permitted to measure the change in the intrinsic value of the written option (or net written option) combined with the change in fair value of the hedged item.

Pursuant to paragraph 20(c)(1) and the guidance in Statement 133 Implementation Issue No. E2, "Combinations of Options," the combination of options in the example collar in the Background section is a net written option from the equity security holder's perspective. Therefore, the special written-option test in paragraph 20(c) must be applied to determine whether the hedging relationship between the equity security and the collar qualifies for fair value hedge accounting. That test requires consideration of the potential gain and loss on the combined collar and equity security for all percentage changes in the equity index. Performance of that analysis demonstrates that the combination of the hedged item's price change and the net written option's intrinsic value change provides at least as much potential for gains as a result of a favorable change in their respective prices as exposure to losses from an unfavorable change in their respective prices.

The calculations in the table in the Background section demonstrate that the example hedging relationship would fail the written-option test in paragraph 20(c) if the time value were required to be considered. The amount of the gain and the loss on the combination of the net written option (both time value and intrinsic value) and the equity security when the underlying equity price increases and decreases by the same percentage is not equivalent or symmetrical. That outcome is due to the fact that the purchased put and written call have different time values, and for a specific change in the underlying, the relative change in time value for each option will be different.

Question 2

No. The special written-option test in paragraph 20(c) must be applied only at inception of the hedging relationship. Otherwise, collar-based hedging relationships would generally fail the symmetry test as the underlying moves in a manner that causes the written-option portion of the collar to approach having intrinsic value. Therefore, a requirement to apply the symmetry test in paragraph 20(c) on an ongoing basis would effectively prohibit collar-based hedging relationships from receiving hedge accounting for the written-option portion of the collar.

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.