Derivatives Implementation Group

Statement 133 Implementation Issue No. E19

QUESTIONS

In documenting a hedging relationship that involves an option contract designated as the hedging instrument:

1. May an entity exclude from the assessment of hedge effectiveness a component of the change in an option's time value in a manner other than the method specified in paragraph 63(b) of Statement 133? For example, may a company exclude changes in an option's time value attributable to the passage of time (theta) from the assessment of hedge effectiveness? (The remaining components of changes in the option's time value would be included in the assessment of hedge effectiveness.)

    

2. May an entity assess hedge effectiveness based on the difference at a point in time between the strike price and forward price (undiscounted) of the referenced asset? (The remaining components of an option's time value at a point in time would be excluded from the assessment of hedge effectiveness and included currently in earnings.)

BACKGROUND

Paragraph 63 of Statement 133 states, in part:

    In defining how hedge effectiveness will be assessed, an entity must specify whether it will include in that assessment all of the gain or loss on a hedging instrument. This Statement permits (but does not require) an entity to exclude all or part of the hedging instrument's time value from the assessment of hedge effectiveness, as follows:

 

1. If the effectiveness of a hedge with an option contract is assessed based on changes in the option's intrinsic value, the change in the time value of the contract would be excluded from the assessment of hedge effectiveness.

    

2. If the effectiveness of a hedge with an option contract is assessed based on changes in the option's minimum value, that is, its intrinsic value plus the effect of discounting, the change in the volatility value of the contract would be excluded from the assessment of hedge effectiveness....

In each circumstance above, changes in the excluded component would be included currently in earnings, together with any ineffectiveness that results under the defined method of assessing ineffectiveness. As noted in paragraph 62, the effectiveness of similar hedges generally should be assessed similarly; that includes whether a component of the gain or loss on a derivative is excluded in assessing effectiveness. No other components of a gain or loss on the designated hedging instrument may be excluded from the assessment of hedge effectiveness.

Background Specific to Question 1

Some entities may wish to assess hedge effectiveness based on the change in an option's value excluding a certain aspect of the change in the option's time value. For example, some entities may wish to exclude the change in time value attributable to the passage of time (theta) from the assessment of hedge effectiveness, while assessing hedge effectiveness based on the remaining components of changes in an option's value. As an illustration, when out-of-the-money options are designated as hedging instruments, changes in value of the option are primarily driven by the change, if any, in the value of the underlying (delta). If the price of the underlying asset changes, in effective hedging strategies involving out-of-the-money options, the hedge gain or loss due to delta would offset the change in value of the hedged item; however, if the price of the underlying does not change, there is no change in fair value attributable to changes in delta. In that case, the only change in the option's value is attributable to the passage of time (theta), or to changes in other market variables such as volatilities or interest rates. Accordingly, for those hedging relationships to qualify for hedge accounting, an entity may need to exclude the change in value attributable to theta from the assessment of hedge effectiveness.

Other entities may wish to exclude changes in time value attributable to certain market variables-volatility (vega) or interest rates (rho)-from the assessment of hedge effectiveness. An entity may wish to exclude changes in time value attributable to volatility (vega) from the assessment of hedge effectiveness because the fair value measurement of the hedged item does not incorporate a measure of implied volatility. Similarly, an entity may seek to exclude changes in time value attributable to interest rates (rho) from the assessment of hedge effectiveness. For example, in a foreign currency hedge involving a country in which interest rates are volatile, a substantial portion of the change in value of the option may be attributable to fluctuations in those interest rates, while the fair value of the hedged item is not affected correspondingly. Accordingly, for these hedging relationships to qualify for hedge accounting, an entity may need to exclude the change in value attributable to the relevant market variable from the assessment of hedge effectiveness.

In summary, the exclusion of a certain aspect of the change in an option's time value from the assessment of hedge effectiveness is driven by the fact that, in certain circumstances, the measurement of changes in fair value of the hedged item or changes in the cash flows of the hedged transaction does not depend upon or incorporate that aspect. Option valuation models are capable of isolating the various aspects of changes in an option's time value.

Background Specific to Question 2

The total value of an option at a point in time can be separated into two components: time value and intrinsic value. As reflected in paragraph 30(a) of Statement 133, an option's time value is the difference between the total option value and its intrisic value. While Statement 133 does not define intrinsic value, FASB Statement No. 123 (revised 2004), Share-Based Payment, provides the following definition of intrinsic value: "The amount by which the fair value of the underlying stock exceeds the exercise price of an option. For example, an option with an exercise price of $20 on a stock whose current market price is $25 has intrinsic value of $5..."

Market convention considers there to be different "measures" of intrinsic value of an option, as described below:

1. The difference between the strike price and the spot price of the underlying asset. (That measure is described in paragraph 63(a) as assessing hedge effectiveness based on intrinsic value.)

    

2. The present value of the difference between the strike price and the forward price of the underlying asset. (That measure is described in paragraph 63(b) as assessing hedge effectiveness based on minimum value.)

    

3. The difference between the strike price and the forward price of the underlying, undiscounted. (Paragraph 63 does not recognize use of that measure as a method of assessing hedge effectiveness.)

RESPONSE

Question 1

Yes, entities may exclude one or more of the following components of the change in an option's time value from the assessment of hedge effectiveness:

1. The portion of the change in time value attributable to the passage of time (theta)

    

2. The portion of the change in time value attributable to changes due to volatility (vega)

    

3. The portion of the change in time value attributable to changes due to interest rates (rho).

However, entities may not exclude from the assessment of hedge effectiveness the portion of the change in time value attributable to changes in other market variables (that is, other than rho and vega).

In computing the changes in an option's time value that would be excluded from the assessment of hedge effectiveness, entities must use a technique that appropriately isolates those aspects of the change in time value. Generally, in order to allocate the total change in an option's time value to its different aspects—the passage of time and the market variables—the change in time value attributable to the first aspect to be isolated is determined by holding all other aspects constant as of the beginning of the period. Each remaining aspect of the change in time value is then determined in turn in a specified order based on the ending values of the previously isolated aspects.

Based on that general methodology, in cases where only one aspect of the change in time value is excluded from the assessment of hedge effectiveness (for example, theta), that aspect must be the first aspect for which the change in time value is computed and would be determined by holding all other parameters constant for the period used for assessing hedge effectiveness. However, in cases where more than one aspect of the change in time value is excluded from the assessment of hedge effectiveness (for example, theta and vega), entities must determine the amount of that change in time value by isolating each of those two aspects in turn in a pre-specified order (one first, the other second). The second aspect to be isolated would be based on the ending value of the first isolated aspect and the beginning values of the remaining aspects. The portion of the change in time value that is included in the assessment of effectiveness is determined by deducting from the total change in time value the portion of the change in time value attributable to excluded components.

In accordance with paragraph 63, changes in the excluded component of the change in an option's time value must be included currently in earnings. Also, entities may not exclude any aspect of a change in an option's value from the assessment of hedge effectiveness that is not one of the permissible components of the change in an option's time value. In addition, the requirement in paragraph 62 that the effectiveness of similar hedges generally should be assessed similarly requires that entities consistently exclude a specific component of option time value in assessing effectiveness for similar hedges. As part of that requirement, the mechanics of isolating the change in time value discussed in the paragraphs above must be applied consistently.

Question 2

Yes, but for cash flow hedges only. That is, with respect to an option designated as the hedging instrument in a cash flow hedge, an entity may assess hedge effectiveness based on a measure of the difference, as of the end of the period used for assessing hedge effectiveness, between the strike price and forward price of the underlying, undiscounted. In the area of cash flow hedge accounting, there is flexibility in the measurement of the change in value of the hedged cash flow. That is, while Statement 133 requires that the measurement of cash flow hedge effectiveness be performed by comparing the changes in present value of the expected future cash flows of the forecasted transaction to the change in fair value of the derivative (aside from any excluded component under paragraph 63), that measure of changes in the expected future cash flows of the forecasted transaction based on forward rates, undiscounted, is not prohibited. Accordingly, assessing hedge effectiveness based on a similar measure with respect to the hedging instrument eliminates any difference that the effect of discounting may have on the hedging instrument and the hedged transaction.

As part of the overall documentation for each hedging relationship, entities must document the measure of intrinsic value that will be used in the assessment of hedge effectiveness. That measure must be used consistently for each period following designation of the hedging relationship.

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.