Cash Flow Hedges Combinations of Options Involving One Written Option and Two Purchased Options

Cash Flow Hedges: Combinations of Options Involving One Written Option and Two Purchased Options

Derivatives Implementation Group

Statement 133 Implementation Issue No. G15

Title: Cash Flow Hedges: Combinations of Options Involving One Written Option and Two Purchased Options
Paragraph references:

29

Date cleared by Board: December 6, 2000

QUESTION

For a hedging relationship in which a combination of options (deemed to be a net purchased option) is designated as the hedging instrument and the effectiveness of the hedge is assessed based only on changes in intrinsic value of the combination of options, may the assessment of effectiveness be based only on changes in the underlying that cause a change in the intrinsic value of the hedging instrument (the combination of options)? In other words, may the assessment of effectiveness exclude ranges of changes in the underlying for which there is no change in the hedging instrument's intrinsic value? Specifically, is the example hedging relationship illustrated in the Background section involving a combination of options considered effective at offsetting the change in cash flows due to foreign currency exchange rate movements related to the forecasted transaction?

BACKGROUND

JPN is a Japanese subsidiary of a U.S. company. JPN's functional currency is the Japanese Yen. JPN has forecasted inventory purchases to be paid in U.S. dollars (USD). As a result, JPN is exposed to changes in the Yen-USD exchange rate: its functional currency cash outflows will increase (loss) if the Yen weakens versus the USD and decrease (gain) if the Yen strengthens versus the USD. JPN would like to hedge the foreign currency exposure related to the forecasted transaction by entering into a combination of foreign-currency-denominated option contracts designated as a single hedging instrument. For purposes of this discussion, it is assumed that JPN has met the qualifying criteria regarding forecasted transactions eligible for designation as hedged transactions pursuant to paragraph 29 of Statement 133 and that the options are entered into contemporaneously with the same counterparty and can be transferred independently of each other. Also, assume that the combination of foreign currency option contracts meets all of the conditions in Statement 133 Implementation Issue No. E2, "Combinations of Options," to be considered a net purchased option (that is, considered not to be a net written option subject to the requirements of paragraph 28(c)).

JPN employs the following hedging strategy:

  • The forecasted transaction is estimated at $150,000,000. The at-the-money forward rate is 120 Yen per USD (¥120/USD1).

  • JPN's documented hedge objective is to offset the foreign exchange risk to the functional currency equivalent cash flows at levels above ¥125/USD1 and in the range from ¥113/USD1 to ¥108/USD1. In the range ¥113/USD1 to ¥125/USD1 and at levels below ¥108/USD1, JPN chooses not to offset the foreign exchange risk to the functional currency equivalent cash flows.

  • To implement this hedge objective, JPN enters into the following option contracts and jointly designates them as the hedging instrument:

    1. One purchased option that gives JPN the right to purchase $150,000,000 at an exchange rate of ¥125/USD1. Premium paid: $1,536,885.
    2. One sold (written) option that, if exercised, obligates JPN to purchase $150,000,000 at an exchange rate of ¥113/USD1. Premium received: $1,536,885.
    3. One purchased option that gives JPN the right to sell $150,000,000 at an exchange rate of ¥108/USD1. Premium paid: $737,705.

The time value of the combination of options is to be excluded from the assessment of effectiveness and, therefore, effectiveness is based only on changes in intrinsic value related to the combination of options.

The purpose of Option 1 is to protect JPN when the Yen-USD exchange rate increases above ¥125/USD1. As the Yen-USD exchange rate increases, JPN will be required to purchase the $150,000,000 inventory at a greater Yen-equivalent cost. As the Yen-USD exchange rate increases above ¥125/USD1, the intrinsic value of the option increases as the option is increasingly in-the-money. That increase in the option's intrinsic value is expected to offset the increase in the Yen-equivalent expenditure on the forecasted transaction.

JPN also writes an option (Option 2) that obligates JPN to purchase USD from the counterparty at an exchange rate of ¥113/USD1. The counterparty will exercise the option whenever the Yen-USD exchange rate is below ¥113/USD1. As the Yen-USD exchange rate decreases, JPN will be required to purchase the $150,000,000 inventory at a lesser Yen-equivalent cost. As the Yen-USD exchange rate decreases below ¥113/USD1, JPN's losses related to increases in the intrinsic value of the written option are expected to offset the decrease in the Yen-equivalent expenditure on the forecasted transaction.

JPN also purchases an option to sell USD (Option 3) for a notional amount equal to the notional of the written option (Option 2) with a strike price of ¥108/USD1. JPN will exercise Option 3 whenever the Yen-USD exchange rate is below ¥108/USD1. When the exchange rate is below ¥108/USD1, although JPN will be obligated to make payment in relation to Option 2, it will also receive a payment in relation to Option 3. As a result of purchasing Option 3, JPN will be exposed to exchange rate fluctuations on Option 2 only when the exchange rate is between ¥113/USD1 and ¥108/USD1. Hence, with Options 2 and 3, JPN has effectively limited its hedge offset to changes in cash flows on the forecasted item to levels between ¥113/USD1 and ¥108/USD1. Changes in the exchange rate below ¥108/USD1 result in no change in the intrinsic value of the combination of options because the change in Option 2 offsets the change in Option 3. However, when the exchange rate is below ¥108/USD1, the combination of options has an intrinsic value other than zero.

In summary, potential changes in intrinsic value related to this combination option hedge construct (Options 1, 2 and 3) would limit the hedge offset to corresponding changes in functional currency cash flows on the forecasted transaction only at levels above ¥125/USD1 and in the range ¥108/USD1 to ¥113/USD1, consistent with JPN's documented hedge objective.

RESPONSE

Yes. In a hedging relationship in which a combination of options (deemed to be a net purchased option) is designated as the hedging instrument and the effectiveness of the hedge is assessed based only on changes in intrinsic value of the hedging instrument (the combination of options), the assessment of effectiveness may be based only on changes in the underlying that cause a change in the intrinsic value of the hedging instrument (the combination of options). Thus, the assessment can exclude ranges of changes in the underlying for which there is no change in the hedging instrument's intrinsic value.

The example cash flow hedging relationship illustrated in the Background section involving a combination of options may be considered effective at offsetting the change in cash flows due to foreign currency exchange rate movements related to the forecasted transaction. Specifically, JPN may assess the effectiveness of the hedge based only on changes in the underlying that cause a change in the intrinsic value of the combination of options. Thus, in that case, JPN would assess effectiveness of the hedge only when the Yen-USD exchange rate is above ¥125/USD1 and between ¥113/USD1 and ¥108/USD1. Likewise, JPN's assessment would exclude changes in the Yen-USD exchange rate between ¥113/USD1 and ¥125/USD1 and below ¥108/USD1.

The combination of options used by JPN as a hedging instrument is deemed to be a net purchased option based on the provisions in Statement 133 and the guidance in Implementation Issue E2. Therefore, the hedging relationship avoids being subject to the special hedge effectiveness test for written options in paragraph 28(c). In particular, as it relates to Condition 1 of Implementation Issue E2, the aggregate premium (that is, the time values) for the three options comprising the hedging instrument results in JPN paying a net premium. The evaluation of whether a net premium has been received (Implementation Issue E2, Condition 1) must include consideration of only the time value components of the options designated as the hedging instrument. That evaluation must not include the intrinsic value, if any, of the options.

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.