FASB Hedging-General Complex Combinations of Options

FASB: Hedging-General: Complex Combinations of Options

Derivatives Implementation Group

Statement 133 Implementation Issue No. E5

Title: Hedging—General: Complex Combinations of Options
Paragraph references: 20(c)(1), 28(c)
Date cleared by Board: November 23, 1999

QUESTION

If the strike prices, the notional amounts, or both of either the written option component or the purchased option component within a combination of options do not remain constant over the life of the respective component, how should the combination of options be evaluated when applying the criteria for determining whether the combination of options can be considered not to be a written option (that is, be considered to be a net purchased option or zero cost collar)?

BACKGROUND

Statement 133 addresses when a combination of options (that is, a combination of a written option and a purchased option, whether in separate option contracts or embodied in a single contract) must be viewed as a written option, in which case it is subject to the effectiveness test in paragraph 20(c) of Statement 133 for fair value hedges and in paragraph 28(c) of Statement 133 for cash flow hedges. Paragraph 20(c)(1) of Statement 133 states:

     A combination of options (for example, an interest rate collar) 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.) Furthermore, a derivative instrument that results from combining a written option and any other nonoption derivative shall be considered a written option.

Paragraph 28(c) of Statement 133 effectively incorporates the requirements of paragraph 20(c)(1) of Statement 133 by a specific reference to that subparagraph.

FASB staff guidance presented in Statement 133 Implementation Issue No. E2, "Hedging-General: Combinations of Options," addresses whether the written and purchased components of a combination of options must be based on the same underlying and have identical terms (such as number of units and maturity dates) to be considered not to be a written option (that is, be considered to be a net purchased option or zero cost collar). However, the response does not address a combination of options in which either the strike price or the notional amount in either the written option component or the purchased option component can fluctuate over the life of the respective component.

The following examples illustrate contracts with such fluctuations. For purposes of the illustration, assume a company wishes to hedge its forecasted sales of a commodity by entering into a five-year commodity-price collar. Under the collar, the company will (a) purchase commodity-price put option components (a floor) and (b) write commodity-price call option components (a cap). Assume that each of the alternative collars discussed otherwise meets the criteria established in Issue E2. That is, for each collar:

1. No net premium is received at inception of the combination of options. (This question considers, in part, whether a net premium is received at any point during the life of the combination of options that the strike price or notional amount is changed.)

2. The components of the combination of options are based on the same underlying (that is, the same commodity price).

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. (This question considers, in part, whether criterion 4 should be applied to only the entire contractual term to maturity or to some part thereof.)

Example 1-Changes in Strike Prices

The following table presents (1) commodity prices implied by the forward price curve based on market prices and (2) the strike prices of two alternative collars. The "minimum" prices for each collar represent the strike prices of the purchased put options. The "maximum" prices for each collar represent the strike prices of the written call options. (Assume that the notional amounts of the two option components are identical and constant over the life of the option components.)

(Cents Per Unit)
5-Year
20X2
20X3
20X4
20X5
20X6
Average
Forward price

100.0

103.9

105.6

106.4

106.7

104.5

Collar 1
   Minimum

98.3

98.3

98.3

98.3

98.3

98.3

   Maximum

110.6

110.6

110.6

110.6

110.6

110.6

Collar 2
   Minimum

108.5

108.5

91.5

91.5

91.5

98.3

   Maximum

108.5

108.5

108.5

110.4

117.2

110.6

Note that the 5-year averages of (a) the minimum prices (98.3 cents) and (b) the maximum prices (110.6 cents) of the 2 collars are identical and are consistent with the 5-year average implied by the forward price curve. (That is, 104.5 cents equals the average of the 98.3-cent minimum strike price and the 110.6-cent maximum strike price.) No net premium is received at inception for either collar taking into consideration the entire contractual term of the combination of options from inception to maturity.

Example 2- Changes in Notional Amounts

The following table presents the notional amounts of two alternative collars. (Assume that the strike prices of the two collars are identical and constant over the life of the collars.)

(Notional Units)
Total
Notional
5-Year
20X2
20X3
20X4
20X5
20X6
Amount
Average
Collar 3
   Minimum

750

750

750

750

750

3,750

750

    Maximum

750

750

750

750

750

3,750

750

Collar 4
   Minimum

1,240

1,240

1,240

15

15

3,750

750

   Maximum

250

250

250

1,500

1,500

3,750

750

Note that both the sum and average of the notional amounts of the written option component for all periods are not greater than the sum and average of the notional amounts of the purchased option component for all periods.

RESPONSE

If either the written option component or the purchased option component for a combination of options has either strike prices or notional amounts that do not remain constant over the life of the respective component, the assessment to determine whether that combination of options can be considered not to be a written option under paragraph 20(c)(1) should be evaluated with respect to each date that either the strike prices or the notional amounts change within the contractual term from inception to maturity. Even though that assessment is made on the date that a combination of options is designated as a hedging instrument (to determine the applicability of paragraphs 20(c) and 28(c)), it must consider the receipt of a net premium (in cash or as a favorable rate or other term) from that combination of options at each point in time that either the strike prices or the notional amounts change.

When strike prices fluctuate over the life of a combination of options and no net premium is received at inception, a net premium will typically be received as a favorable term in one or more reporting periods within the contractual term from inception to maturity. For Collar 2 in Example 1, premiums are received in early periods as consideration for entering into net written options in later periods. Specifically, the (higher-than-average) strike prices in years 20X2 and 20X3 are received (that is, receipt of a "net premium") in return for accepting less favorable (lower-than-average) strike prices in years 20X4 through 20X6 (that is, net written options). Thus, at the inception of the hedge and over its life, Collar 2 would be subject to the provisions of paragraphs 20(c) and 28(c).

When notional amounts fluctuate over the life of a combination of options and no net premium is received at inception, a net premium or a favorable term will typically be received in one or more periods within the contractual term from inception to maturity. For Collar 4 in Example 2, favorable terms are received in early periods (net purchased options) as consideration for entering into net written options in later periods. Specifically, the (higher-than-average) notional amounts on the purchased put option in years 20X2 through 20X4 are received in return for accepting a less favorable notional amount in years 20X5 and 20X6. Thus, at the inception of the hedge and over its life, Collar 4 would be subject to the provisions of paragraphs 20(c) and 28(c).

In addition, a combination of options in which either the written option component or the purchased option component has either strike prices or notional amounts that do not remain constant over the life of the respective component must satisfy the four conditions in Issue E2 to be considered not to be a written option (that is, to be considered to be a net purchased option or zero cost collar) under paragraph 20(c)(1). For example, if the notional amount of the written option component is greater than the notional amount of the purchased option component at any date that the notional amount changes within the contractual term from inception to maturity, the combination of options should be considered to be a written option under paragraph 20(c)(1) and, thus, subject to the criteria in paragraphs 20(c) and 28(c).

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.