Derivatives Implementation Group

Statement 133 Implementation Issue No. E18

QUESTION

In a hedging relationship in which a collar that is comprised of a purchased option and a written option that have different notional amounts is designated as the hedging instrument and the hedge's effectiveness is assessed based on changes in the collar's intrinsic value, may the hedged item be specified as two different proportions of the same asset based on the upper and lower rate or price range of the asset referenced in the collar?

• In Example 1 in the Background section, may Company A designate as the hedged risk the change in fair value of 1,000 shares of XYZ stock (100 percent of the portfolio) resulting from price changes below $100 per share and the change in fair value of 70 percent of each of the 1,000 shares in the portfolio resulting from price changes above $120 per share?

   

• In Example 2 in the Background section, may Company B, whose functional currency is the U.S. dollar, designate as the hedged risk the variability in U.S. dollar-equivalent cash flows on FC100 million (100 percent of the forecasted foreign-currency-denominated purchase price of inventory) resulting from changes in the U.S. dollar-FC exchange rate above $0.885 per FC1 and the variability in U.S. dollar-equivalent cash flows on FC50 million (50 percent of the forecasted FC100 million purchase price of inventory) resulting from changes in the U.S. dollar-FC exchange rate below $0.80 per FC1?

BACKGROUND

Example 1-Equity Collar

During January 1999, Company A issued a $100,000 debt instrument at a fixed interest rate of 8 percent that contains an embedded combination of options. The combination of options is comprised of the following:

• A purchased put option with a notional amount equal to 1,000 shares of XYZ stock and a strike price of $100 per share. The purchased put option provides Company A a return of $1,000 for each dollar that the price of XYZ stock falls below $100.

   

• A written call option with a notional amount equal to 700 shares of XYZ stock and a strike price of $120 per share. The written call option obligates Company A to pay $700 for each dollar that the price of XYZ stock increases above $120.

Overall, the collar provides the investor with a potential gain equal to 70 percent of the share price of XYZ stock in excess of $120 per share at maturity and exposes the investor to a potential loss in principal to the extent that the share price of XYZ stock is below $100 per share at maturity. (For both options, the underlying is the same-the share market price of XYZ stock.)

Company A also has 1,000 shares of XYZ stock classified as available-for-sale. The current market value of XYZ stock at the debt issuance date is $100 per share. The debt issuance is intended to eliminate the risk of a decrease in the market value in Company A's investment in XYZ stock.

According to paragraph 50 of Statement 133, as amended by FASB Statement No. 137, Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of FASB Statement No. 133, at the initial adoption of Statement 133, Company A must separately account for the embedded derivative in its debt issuance. (The "grandfathering" provision related to embedded derivatives cannot be applied in this case.) Based on the guidance in Statement 133 Implementation Issue No. B15, "Separate Accounting for Multiple Derivative Features Embedded in a Single Hybrid Instrument," that embedded combination of options may not be separated into its components.

Statement 133 Implementation Issue No. E2, "Combinations of Options," includes the following criteria, which must be met in order for a combination of option contracts, including the combination of a single purchased option contract and a single written option contract, to result in a net purchased option or a zero-cost collar.

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.

Pursuant to the guidance in Implementation Issue E2, the combination of options should be accounted for as a net purchased option. As a result, if Company A chooses to use the combination of options as a hedging instrument, it is not required to comply with the provisions contained in paragraph 20(c) related to written options.

Upon adoption of Statement 133, Company A would like to designate the combination of options as a fair value hedge of its investment in XYZ stock. Assume Company A specifies in the hedge effectiveness documentation that the collar's time value would be excluded from the assessment of hedge effectiveness.

Example 2-Currency Collar

Company B forecasts that it will purchase inventory that will cost 100 million foreign currency (FC) units. Company B's functional currency is the U.S. dollar. To limit the variability in U.S. dollar-equivalent cash flows associated with changes in the U.S. dollar-FC exchange rate, Company B constructs a currency collar as follows:

• A purchased call option providing Company B the right to purchase FC100 million at an exchange rate of $0.885 per FC1.
• A written put option obligating Company B to purchase FC50 million at an exchange rate of $0.80 per FC1.

The purchased call option provides Company B with protection when the U.S. dollar-FC exchange rate increases above $0.885 per FC1. The written put option partially offsets the cost of the purchased call option and obligates Company B to give up some of the foreign currency gain related to the forecasted inventory purchase as the U.S. dollar-FC exchange rate decreases below $0.80 per FC1. (For both options, the underlying is the same-the U.S. dollar-FC exchange rate.) Assuming that a net premium was not received for the combination of options and all the other criteria in Implementation Issue E2 have been met, if Company B chooses to use the combination of options as a hedging instrument, it is not required to comply with the provisions contained in paragraph 20(c) related to written options.

Company B would like to designate the combination of options as a hedge of the variability in U.S. dollar-equivalent cash flows of its forecasted purchase of inventory denominated in FC. Assume Company B specifies in the hedge effectiveness documentation that the collar's time value would be excluded from the assessment of hedge effectiveness.

RESPONSE

Yes. In a hedging relationship in which a collar that is comprised of a purchased option and a written option that have different notional amounts is designated as the hedging instrument and the hedge's effectiveness is assessed based on changes in the collar's intrinsic value, the hedged item may be specified as two different proportions of the same asset referenced in the collar, based on the upper and lower price ranges specified in the two options that comprise the collar. (That is, the quantities of the asset designated as being hedged may be different based on those price ranges in which the collar's intrinsic value is other than zero.)

The application of the guidance in this issue is permitted only for collars that are a combination of a single written option and a single purchased option for which the underlying in both options is the same. The guidance in this issue may not be applied by analogy to other derivatives designated as hedging instruments.

While the quantities of the asset designated as being hedged may be different based on the upper and lower price ranges in the collar, the actual assets that are the subject of the hedging relationship may not change. The quantities that are designated as hedged for a specific price or rate change must be specified at the inception of the hedging relationship and may not be changed unless the hedging relationship is dedesignated and a new hedging relationship is redesignated. Since the hedge's effectiveness is based on changes in the collar's intrinsic value, the assessment of hedge effectiveness must compare the actual change in intrinsic value of the collar to the change in value of the pre-specified quantity of the hedged asset that occurred during the hedge period.

In Example 1 in the Background section, the hedging relationship involving the equity collar and the shares of XYZ stock owned by Company A qualifies for fair value hedge accounting. In that case, the hedged risk is changes in the overall fair value of the hedged item. The hedged item is expressed as 100 percent of 1,000 shares of XYZ stock for price changes below $100 per share and 70 percent of each of the same 1,000 shares of stock for price changes above $120 per share. Fair value hedge accounting will be applied for those changes in the underlying (market price of XYZ stock) that cause changes in the collar's intrinsic value (that is, decreases below $100 per share and increases above $120 per share). Since the hedge's effectiveness is based on changes in the collar's intrinsic value, hedge effectiveness must be assessed based on the actual price change of XYZ stock by comparing the change in intrinsic value of the collar to the change in fair value of the specified quantity of shares for those changes in the underlying.

In Example 2 in the Background section, the hedging relationship involving the currency collar designated as a hedge of the effect of fluctuations in the U.S. dollar-FC exchange rate qualifies for cash flow hedge accounting. In that example, the hedged risk is the risk of changes in U.S. dollar-equivalent cash flows attributable to foreign currency risk (specifically, the risk of fluctuations in the U.S. dollar-FC exchange rate). The foreign currency collar is hedging the variability in U.S. dollar-equivalent cash flows for 100 percent of the forecasted FC100 million purchase price of inventory for U.S. dollar-FC exchange rate movements above $0.885 per FC1 and variability in U.S. dollar-equivalent cash flows for 50 percent of the forecasted FC100 million purchase price of inventory for U.S. dollar-FC exchange rate movements below $0.80 per FC1. Cash flow hedge accounting will be applied for those changes in the underlying (the U.S. dollar-FC exchange rate) that cause changes in the collar's intrinsic value (that is, changes below $0.8 per FC1 and above $0.885 per FC1). Since the hedge's effectiveness is based on changes in the collar's intrinsic value, hedge effectiveness must be assessed based on the actual exchange rate changes by comparing the change in intrinsic value of the collar to the change in the specified quantity of the forecasted transaction for those changes in the underlying.

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.