FASB Cash Flow Hedges Defining the Risk Exposure for Hedging Relationships involving an Option Contract as the Hedging Instrument

FASB: Cash Flow Hedges: Defining the Risk Exposure for Hedging Relationships involving an Option Contract as the Hedging Instrument

Derivatives Implementation Group

Statement 133 Implementation Issue No. G11

Title: Cash Flow Hedges: Defining the Risk Exposure for Hedging Relationships involving an Option Contract as the Hedging Instrument
Paragraph reference:
63
Date cleared by Board: June 28, 2000
Date posted to website: July 11, 2000
Date revision posted to website: December 10, 2001
(Revised November 21, 2001)

QUESTION

When a purchased option is designated as a hedging instrument, may the time value component of that option be included in defining limited parameters for the hedged risk exposure? Specifically, may a company define its risk exposure as currency exchange rate changes above the sum of the strike price and the time value component at the inception of the hedging relationship (that is, in the example in the Background section, as currency exchange rate changes above $1.65 per pound sterling)?

BACKGROUND

XYZ Company, a U.S. dollar functional currency company, forecasts the purchase of goods with the payment denominated in pound sterling. To hedge the foreign currency exposure from the forecasted purchase, XYZ Company purchases an at-the-money call option on pound sterling. The notional amount of the option equals the forecasted value of goods to be purchased, and the option exercise date is the date the purchase consummates. At inception of the hedging relationship the strike price and the forward market exchange rate for one pound sterling are both $1.50. The time value component on the option is $0.15 per pound sterling.

RESPONSE

No. When a purchased option is designated as a hedging instrument, an entity cannot define only limited parameters for the risk exposure designated as being hedged that would include the time value component of that option. The foreign currency option in the above example could be effective as a hedging instrument only if (a) effectiveness for that hedging relationship were based solely on changes in the option's intrinsic value or (b) effectiveness for that hedging relationship were based solely on changes in the option's entire fair value. When an entity has documented that the effectiveness of a cash flow hedge will be assessed based on changes in the hedging option's intrinsic value pursuant to paragraph 63(a), that assessment (and the related cash flow hedge accounting) must be performed for all changes in intrinsic value-that is, for all periods of time when the option has an intrinsic value, such as when the underlying is above the strike price of the call option in the above example. Therefore, in the above example, it is inappropriate to assert that only limited risk exposures are being hedged, such as exposures related only to currency exchange rate changes above $1.65 per pound sterling. An entity cannot arbitrarily exclude some portion of an option's intrinsic value from the hedge effectiveness assessment simply through an articulation of the risk exposure definition.

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.