FAS 133 Option Fair Value Hedges:
Financial-Engineering and Financial-Accounting Perspectives with Dan
Thornton, January 2001, last revised September 2001
FAS
133 (as amended by FAS 138) states that “derivative instruments like other
financial assets and liabilities shall be measured at fair value, and
adjustments to the carrying amounts of hedged items should reflect changes in
fair value.” [FAS 133-paragraph 217(b)] Particularly
with regard to option hedges, the standard parses fair value into “time
value” and “intrinsic value” components.
In order to have an “effective” option hedge, application of hedge
accounting often identifies intrinsic value to be the offset for changes in the
hedged item value. Therefore, time
value becomes a residual fair value component that to generates earnings
variability. We believe that this
time value-induced earnings variability is inappropriate for purchased options
that will be held to the maturity of a hedge.
To focus this view, we first value FAS 133-induced earnings changes. This valuation is based on the standard equivalent risk-neutral probability or martingale-pricing framework. This exercise highlights a canonical financial engineering response to this standard: Time Value Swaps (TVS). We illustrate how a variable TVS reduces time value induced earnings changes. More importantly, we show how coupling a “fixed” TVS with variable time value-based option payments can largely fix period-to-period time value-related earnings adjustments. Under this contract and related swap structure, option time values may, effectively, be amortized.
Our
accounting-based perspective looks through the FAS 115 “held to
maturity” convention
for qualifying fixed-income transactions and the “available for sale”
convention generally. For cases in
which an option hedge will be held to the maturity, we suggest that the
option need not be marked-to-market. Instead,
the option-related cost or receipt would be amortized over the hedge’s life
against earnings in any standard manner. Alternatively, treating the time value of an option that will
be held to maturity as an available for sale security would have time value
changes entered as adjustments to other comprehensive income and not be charged
to earnings until maturity. In our
appendix, we address a particular Derivatives Implementation Group (DIG)
held-to-maturity option cash flow hedge rule implementation issue (G20) that has
moved partially in the direction that we suggest. We also note a particular limit of DIG-G20 that motivates TVS
use for cash flow hedges.