An Introduction to the Derivative Instruments

45

The US Gaap FAS 133 allows for cash flow hedges to base the test of effectiveness on total
changes in the options fair value (i.e., option time value may be included in the effectiveness
assessment).

FAS 133 DIG 20: Cash Flow Hedges: Assessing and Measuring the
Effectiveness of a Purchased Option Used in a Cash Flow Hedge
For cash flow hedges (i.e., not allowed for fair value hedges) in which the hedging
instrument is a purchased option or a combination of only options that comprise a net
purchased option or a zero-cost collar/tunnel, FAS 133 allows the effectiveness to be
calculated by comparing the total change in fair value of the hedging instrument and
the change in fair value of a perfectly effective hypothetical hedging instrument. The
change in fair value of that hypothetical hedging instrument can be regarded as a proxy
for the present value in expected future cash flows on the hedged transaction.
As a consequence if the hedging instrument and the hypothetical hedging instrument
have the same terms, the entity would simply record all changes in the hedging options
fair value (including changes in the options time value) in equity.
The hypothetical hedging instrument should have terms that meet the following four
conditions:
1. The critical terms of the hedging instrument (such as its notional amount, underlying
and maturity date, etc.) completely match the related terms of the hedged forecasted
transaction (such as, the notional amount, the variable that determines the variability
in cash flows, and the expected date of the hedged transaction, etc.);
2. The strike (or prices) of the hedging option (or combination of options) matches the
specified level (or levels) beyond (or within) which the entitys exposure is being
hedged;
3. The hedging instruments inflows (outflows) at its maturity completely offset the
change in the hedged transactions cash flows for the risk being hedged; and
4. The hedging instrument can be exercised only on a single date.
As we have just seen, the options time value is treated differently under US Gaap. As there
is a gradual process of convergence between FAS 133 and IAS 39, we hope that IAS 39 will
finally allow the inclusion of option time value in a hedging relationship (which in our opinion
makes a great deal of sense).
2.4.5 IAS 39 Accounting Implications of Options Written Options
IAS 39 permits designating as hedging instruments a purchased option or a combination of
purchased options. A written option cannot be a hedging instrument, either on its own or in
combination with other derivatives unless it is designated as an offset of a purchased option
(e.g., in a tunnel or a collar) and all the following conditions are met:
No net premium is received either at inception or over the life of the options; and
Except for the strike prices, the critical terms and conditions of the written option and
the purchased option are the same (underlying, currency denomination, maturity date, etc).
Also the notional amount of the written option is not greater than the notional amount of
the purchased option.