Derivatives Implementation Group

Statement 133 Implementation Issue No. K3

QUESTION

Should the combinations of purchased and written options described below be considered for accounting purposes as two separate option contracts or as a single forward contract:

1. An embedded (nontransferable) purchased call (put) option and an embedded (nontransferable) written put (call) option executed contemporaneously with the same counterparty as part of a single hybrid instrument?

    

2. A freestanding purchased call (put) option and a freestanding or embedded (nontransferable) written put (call) option that are executed contemporaneously with the same counterparty at inception but where the purchased option may be transferred?

    

3. A freestanding purchased call (put) option and a freestanding or embedded (nontransferable) written put (call) option that are executed contemporaneously with different counterparties at inception?

For the purposes of this question, in all cases, the purchased and written options have the same terms (strike price, notional amount, and exercise date) and the same underlying, and neither of the two options is required to be exercised. The notion of the "same counterparty" encompasses contracts entered into directly with a single counterparty and contracts entered into with a single party that are structured through an intermediary. In addition, consistent with the conclusion in Statement 133 Implementation Issue No. K2, "Are Transferable Options Freestanding or Embedded?" an option incorporated into the terms of a hybrid instrument at inception that is explicitly transferable should be considered a freestanding, rather than an embedded, derivative instrument.

RESPONSE

This section provides separate responses for each of the combinations of options in the question section.

1. A combination of an embedded (nontransferable) purchased call (put) option and an embedded (nontransferable) written put (call) option in a single hybrid instrument that have the same terms (strike price, notional amount, and exercise date) and same underlying and that are entered into contemporaneously with the same counterparty should be considered as a single forward contract for purposes of applying the provisions of Statement 133 and related guidance.¹ Those embedded options are in substance an embedded forward contract because they (a) convey rights (to the holder) and obligations (to the writer) that are equivalent from an economic and risk perspective to an embedded forward contract and (b) cannot be separated from the hybrid instrument in which they are embedded. Even though neither party is required to exercise its purchased option, the result of the overall structure is a hybrid instrument that will likely be redeemed at a point earlier than its stated maturity. That result is expected by both the hybrid instrument’s issuer and investor regardless of whether the embedded feature that triggers the redemption is in the form of two separate options or a single forward contract. (However, if either party is required to exercise its purchased “option” prior to the stated maturity date of the hybrid instrument, the hybrid instrument should not be viewed for accounting purposes as containing one or more embedded derivatives. In substance, the debtor [issuer] and creditor [investor] have agreed to terms that accelerate the stated maturity of the instrument and the exercise date of the “option” is essentially the hybrid’s actual maturity date. As a result, it is inappropriate to characterize the hybrid instrument as containing two embedded option contracts that are exercisable only on the actual maturity date or as containing an embedded forward contract that is a combination of an embedded purchased call [put] and a written put [call] with the same terms.)²
   
   

   Embedded options in a hybrid instrument that are required to be considered a single forward contract under Statement 133 as a result of the guidance contained herein may not be designated individually as hedged items in a fair value hedge in which the hedging instrument is a separate, unrelated freestanding option. Statement 133 does not permit a component of a derivative to be designated as the hedged item.

2. A combination of a freestanding purchased call (put) option and a freestanding or embedded (nontransferable) written put (call) option that have the same terms and same underlying and that are entered into contemporaneously with the same counterparty at inception should be considered for accounting purposes as separate option contracts, rather than a single forward contract, by both parties to the contracts. Derivatives that are transferable are, by their nature, separate and distinct contracts. That is consistent with the conclusion in Implementation Issue K2 which states: "...a call option that is either transferable by the debtor to a third party and thus is potentially exercisable by a party other than the debtor or the original investor based on the legal agreements governing the debt issuance can result in the investor having different counterparties for the option and the original debt instrument. Accordingly, even when incorporated into the terms of the original debt agreement, such an option may not be considered an embedded derivative by either the debtor or the investor because it can be separated from the bond and effectively sold to a third party."

    

3. A combination of a freestanding purchased call (put) option and a freestanding or embedded (nontransferable) written put (call) option that have the same terms and same underlying and that are entered into contemporaneously with different counterparties at inception should be considered for accounting purposes as separate option contracts, rather than a single forward contract, by both parties to the contracts. Similarly, a combination of a freestanding written call (put) option and an embedded (non-transferable) purchased put (call) option that have the same terms and same underlying and that are entered into contemporaneously with different counterparties at inception should be considered for accounting purposes as separate option contracts, rather than a single forward contract, by both parties to the contracts. Separate purchased and written options with the same terms but that involve different counterparties convey rights and obligations that are distinct and do not warrant bundling as a single forward contract for accounting purposes under Statement 133. However, those separate purchased options and written options can be viewed in combination and jointly designated as the hedging instrument pursuant to paragraph 18 of Statement 133.
   
   

   ________________
   ¹A share of stock being puttable by the holder and callable by the issuer under the same terms does not render the stock mandatorily redeemable under the provisions of FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.
   ²Statement 150 requires that mandatorily redeemable financial instruments, as defined in that Statement, be classified as liabilities.

   
   

   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.