Hedge accounting fx options: time versus intrinsic value

FX options make up an element of many companies fx risk management strategies. FX options lock in the certainty of worst case exchange rate outcomes while allowing participation in favourable rate movements. In my experience, companies are often reluctant to write out a cheque for the premium so for many the preferred strategy is collar options. A collar option involves writing, or selling, an fx option simultaneously as buying the fx option in order to reduce premium, often to zero.

After transacting the fx option, the challenge comes for those that are hedge accounting and the requirement to split the valuation of the fx option into time value and intrinsic value. IAS 39 allows the intrinsic value of an fx option to be designated in a hedge relationship and can therefore remain on the balance sheet. The time value of the fx option is recognised through profit or loss.

The intrinsic value of an fx option is the difference between the prevailing market forward rate for the expiry of the fx option versus the strike price. We can use an Australian based exporter to the US as an example. In our example the exporter forward hedged US$1 million of export receipts six months ago (the USD income is due to be received in three months’ time). At the time of hedging the AUD/USD rate was 0.8750 and the nine month forward rate was 0.8580. The company chose to hedge with a nine month zero cost collar[1] (ZCC). Six months’ ago the ZCC might have been as follows:

  • Option 1: Bought USD Put / AUD Call at a strike of 0.9000
  • Option 2: Sold AUD Put / USD Call expiring at a strike of 0.8000

AUD USD

The intrinsic value of each leg of the collar will be determined by the difference in the forward rate at valuation date versus the strike rates. For option 1, the bought option, if the forward rate is above the strike of 0.9000 then the fx option will have positive intrinsic value i.e. it is “in-the-money”. It is important to note that the intrinsic value of a bought fx option cannot be negative. The purchaser, or holder, of the fx option has all of the rights and would not choose to exercise the fx option if the market rate was below the strike price. They would simply choose to walk away from the fx option, let it expire worthless, and transact at the lower market rate.

For the sold fx option the opposite is true. If the forward rate is below the strike price (less than 0.8000 in our example) then the exporter, as the writer of the option, will be exercised upon and the difference between the market rate and the strike rate will be negative intrinsic value. Intrinsic value of a sold fx option cannot be positive.

The time value of an fx option is the difference between the overall fx option valuation and the intrinsic value. By definition, time value is a function of the time left to the expiry of the fx option. The longer the time to expiry, the higher the time value as there is a greater probability of the fx option being exercised. A purchased fx option begins life with positive time value that decays over time to zero. A sold fx option begins life with negative time value and tends to zero by expiry date.

When hedge accounting for fx options the splitting of intrinsic value (balance sheet) and time value (P&L) does not have to be a time consuming exercise. At Hedgebook we like to make life easy so as part of the FX Options Held Report the valuations are automatically split by intrinsic value and time value. The screen shot below shows the HedgebookPro output using our Aussie exporter example. With the significant weakening of the AUD in the last six months we see the zero intrinsic value of the bought option at a strike of 0.9000 and very little time value as there is little chance of the AUD strengthening to above 0.9000 by the time the option expires by 30 June. The sold fx option has a large, negative intrinsic value. The exporter will be exercised upon and have to convert the US$1 million of receipts at AUD/USD 0.8000 versus a market rate of closer to 0.7600. There is a small amount of negative time value.

HedgebookPro FX Options Held Report  

FX Options Held Intrinsic_Time

HedgebookPro’s easy to use Treasury Management System calculates fx option valuations split into intrinsic and time value. This simplifies life for those that already use fx options and hedge account, whilst removing obstacles to hedge accounting for those that perceive the accounting requirements as too hard.

The IASB is looking to remove the requirement to split fx option valuations into intrinsic and time components which will simplify the hedge accounting process further, however, currently this appears to be a 2018 story, unless companies choose to adopt early. In the meantime, HedgebookPro provides an easy to use system to ease the pain of hedge accounting fx options.

[1] Premium received from the sold option offsets the premium paid on the bought option.

Hedging, and a deeper look into the types of Financial Hedges

One of the popular misnomers about hedging is that it is a costly, time-consuming, complicated process. This is not true!

At the end of the day, there are two different types of hedges: natural hedging and financial hedging. It is not uncommon for companies to use one or both methods to implement their hedging strategies in order to protect their bottom line from currency risk.

Natural hedging involves reducing the difference between receipts and payments in the foreign currency. For example, a New Zealand firm exports to Australia and forecasts that it will receive A$10 million over the next year. Over this period, it expects to make several payments totaling A$3 million; the New Zealand firm’s expected exposure to the Australian Dollar is A$7 million. By implementing natural hedging techniques, the New Zealand firm borrows A$3 million, while subsequently increasing acquisition of materials from Australian suppliers by A$3 million. Now, the New Zealand firm’s exposure is only A$1 million. If the New Zealand firm wanted to eliminate nearly all transaction costs, it could open up production in Australia entirely.

Financial hedging involves buying and selling foreign exchange instruments that are dealt by banks and foreign exchange brokers. There are three common types of instruments used: forward contracts, currency options, and currency swaps.

Forward contracts allow firms to set the exchange rate at which it will buy or sell a specified amount of foreign currency in the future. For example, if a New Zealand firm expects to receive A$1 million in excess of what it forecasts to spend every quarter, it can enter a forward contract to sell these Australian Dollars, at a predetermined rate, every three-months. By offsetting the A$1 million with forward contracts every month, nearly all transaction costs are eliminated.

Currency options tend to be favorable for those firms without solidified plans, i.e., a company that is bidding on a contract. Currency options give a company the right, but not the obligation, to buy or sell currency in the future at a specified exchange rate and date. Upfront costs are common with currency options, which can deter small- and medium-sized firms, but the costs are for good reason: currency options allow firms to benefit from favorable exchange rate movement. Like interest rate swaps, whose lives can range from 2-years to beyond 10-years, currency swaps are a long-term hedging technique against interest rate risk, but unlike interest rate swaps, currency swaps also manage risk borne from exchange rate fluctuations.

Exchange rate volatility can affect a company’s hedging strategy – the next post will cover why timing is key.

Hedging Basics: Hedging Using Interest Rate Futures Risk Reversals

Exposure to the interest rate markets can be hedged with many financial instruments. One of the more flexible is the risk reversal.  A key benefit of the risk reversal is that it does not exposure the hedger to immediate gains or losses (similar to a swap or futures contract) as it allows the hedger to create a range in which their exposure is un-hedged.

Futures Contracts
A futures contract is an obligation between two parties to purchase or sell a physical or financial product as some date in the future.  Interest rate futures are traded on exchanges such as the Chicago Mercantile Exchange and provide a clearing platform for traders that eliminate credit risk.

Hedging
The strategy of a risk reversal for a hedger that is looking to mitigate downside exposure to the interest rate market is to purchase a put on an interest rate futures contract and simultaneously sell a call on an interest rate futures contract.  The strike price of the call and the put are generally a certain percentage away from the current spot price, creating a range above and below the current price where the trader is not hedged.  If the price of the futures contract falls below the put, the trader receives a payout.  If the price of the futures contract rises above the call, the trader needs to make a payment.

Hedging Basics: Swaptions

Interest rate options are excellent tools to use to mitigate interest rate exposure.  One robust structure that is used to reduce exposure to monthly periods of interest rate volatility is the interest rate swaption.  This instrument combines the protection of a swap, with the flexibility of a European style option.

Interest Rate Swap
An interest rate swap is a fixed for floating swap which allows an investor or corporate treasurer to reduce their exposure to interest rates by selling or buying a swap.  A pay fixed swap reduces exposure to climbing interest rates while a pay float swap reduces exposure to declining interest rates.

European Option
A European style option is an option in which the purchaser of the option can only exercise the option on the expiration date.  The option is the right but not the obligation to purchase a financial instrument as a specific date in the future.  The strike price is the price at which the buyer and seller of the option agree to buy/sell the financial product.

Interest Rate Swaption
An interest rate Swaption is the right but not the obligation to purchase an interest rate swap on a specific date.  On the expiration date, the owner of the swaption has the right to purchase the swap at the strike price.  A swaption payout profile is similar to a European option.

Hedging Basics: Average Price Currency Options

Late last year we started a series of educations posts relating to the fundamentals of currency hedging. This latest post covers the basic workings of Average Price Currency Options.

The currency markets are volatile markets in which movements between currency pairs can be swift and choppy, changing the direction during political uncertainty or during statement by central banks on monetary policy.  Many treasurers have significant exposure to the currency markets, and hedging using daily operating currency rates can be a significant help in smoothing a corporation’s cash flows.

Average Price Option
An average price option, which is also known as an Asian option, is a financial instrument in which the payout is calculated based on the average price through a specific period.  The period in question can range from a couple of days to multiple years.  Average price options help a treasurer hedge their exposures to the currency markets on a daily basis, removing the daily volatility associated with currency fluctuations.

Average Price Option Payout
Average price currency options generate a different payout profile when compared to European and American style options.  An average price option is calculated by averaging a specific currency rate either using the end of the day price or a mutually agreed upon point, over the period in which the option is active.  For example, a monthly average price option would use the daily average of the trading days during the month.  This level is compared to the strike price, and the difference when multiplied by the volume generates the payout.

Hedging Basics: A Currency Pair Risk Reversal

One of the most interesting strategies that can be used by investors or treasurers to hedge their exposures to the currency markets is a risk reversal.  This type of option structure will hedge a currency pair by protecting against the downside with a put option and financing the put purchase with the sale of a call option.  If a business wanted to hedge an upside directional move in a currency pair they would structure a risk reversal in which they purchased a call and sold a put option.

Call Option Basics
A currency pair call is the right (but not the obligation) to purchase a currency pair at a specific strike, on or before a certain date.  The exchange rate that the parties that transact a currency call is referred to as the strike price, while the date when the option expires is called the expiration date.  The strike prices for the currency call and currency put generally straddle the market price.

The Payout of a Risk Reversal
A business that is protecting against a downward adverse move in a currency pair can use a risk reversal by selling a call and purchasing a put with strike prices that are above and below the market price respectively.  Some attempt to offset the entire cost of the put with a call making the structure a zero cost risk reversal.

If the currency pair at expiration is below the put, the business will receive the difference between the strike price and the price at expiration multiplied by the volume of currency describe in the put option.  If the price of the currency pair is above the call, the business will need to pay away the difference between the strike price and the market price at expiration multiplied by the volume described in the option contract.

Hedging Basics: FX Hedging Using a Currency Put

Currency hedging is a financial exercise in which a treasurer will mitigate their exposure to directional currency movements in an effort to smooth returns or stabilize cash flows. One of the easiest and most effective ways to hedge a currency position is to purchase a protective put, which will offset any losses below a specific strike price.

Put Option Basics
A currency pair put, is the right but not the obligation to sell a designated currency pair at a specific strike, on or before a certain date.  The exchange rate that the parties that transact a currency put is referred to as the strike price, while the date when the option expires is called the expiration date.  European style currency options allow the owner of a put to exercise the put only on the expiration date while American style options allow the flexibility to exercise the option on or before the expiration date.

The Payout of a Currency Put
The payout a currency hedger receives from the purchase of a put is the difference between the spot market of a currency and the strike price of the option at the time the option is exercised.  Options can be settled on a physical basis, where actual currency changes hands at the strike price exchange rate or on a cash basis where one party makes a payment to its counterparty.

“Hedge Accounting and Beyond: Currency Volatility and Movements Aren’t Just Treasury’s Problem”

I came across this nice little article today from Jason Busch of Enterprise Irregulars on the need, during such volatile economic times, for a wider understanding of Hedge Accounting and its role in managing an organization’s currency exposure.

As Busch says, management right across businesses with currency exposure (whether through global sourcing or international sales) need to have a much better understanding of the tools at their disposal, and need to stop relying on their treasury team (if they are lucky enough to have one) to manage these “stormy waters”. It takes a collaborative effort between Treasury and “the business” to make sure that a business is qualifying for hedge accounting, and therefore minimising the impact of currency shifts on their profitability.

As Richard Eaddy commented in his latest article, for most businesses hedge accounting need not be the onerous process that it is perceived as and is a vital tool in helping to ensure that the market volatility doesn’t have to flow through to your company’s income statement. But to Jason Busch’s point, it needs to be a team effort.

Hedge Accounting – where to from here?

When hedge accounting under IAS39 was first introduced in 2005, many nay-sayers (including myself) thought that organisations would move away from worrying about it once the standard was well understood. This was especially so as it seemed overly complicated at the time and administratively a nightmare to comply with. I know of senior partners in accounting firms who decided that they were “too long in the tooth” to invest the time to learn such new concepts and promptly retired.

The reality has been somewhat different. Like many new things, hedge accounting was met with fear and distrust but what was new and scary more than seven years ago is now familiar and normal (albeit with some changes on the way). In fact not only is it now “normal” but where many thought that organisations would move away from worrying about it and would “mark-to-market” all their financial instruments through the Profit and Loss account, we have seen more and more moving towards adopting hedge accounting.

Why is that? For a couple of reasons probably, firstly because hedge accounting is not that difficult if you are reasonably conservative with your risk management. If you stick to plain vanilla type products such as foreign exchange forwards or interest rate swaps and you don’t try and restructure them or push them out too far, then you will easily comply with the standard. Yes you need to do the documentation but that is mostly a simple matter of copying a WordTM document and making a small number of changes. If you have access to independent mark-to-markets of the financial instruments then you can do the hedge effectiveness testing relatively simply, and if you don’t want to do it yourself you can always outsource to an 3rd party who will do it for you.

The other reason why hedge accounting has been more widely adopted (even by those who would prefer not to) is because of the volatility in the financial markets over the last few years that has caused significant movements in the valuations of financial instruments. Volatility in the financial statements is a CFO’s worst nightmare and even though we all know they are unrealised movements, the market still focuses on the bottom line that includes these movements. I am not a financial markets forecaster but I would suggest that volatility is here to stay for the foreseeable future and this alone will continue to drive more and more to hedge account.

The good news is that hedge accounting is going to become easier. IAS 39 is due to be replaced by IFRS 9 and this will mean that complying with the new standard will be simpler than it was under the old one. Gone will be the illogical requirement to split time value out from options which led many to abandon using this useful instrument. Gone also will be the hardline 80 to 125% rule for achieving hedge effectiveness. Now you will be effective for the portion which is effective, not effective if you were 80.1% and ineffective of you were 79.9%.

The final standard is still to be released with likely adoption in 2015 but with the unrelenting volatility in financial markets and a more practical approach to hedge accounting, there is little doubt that the trend we have seen since its original introduction of an increasing uptake is going to continue over the coming years.

 

Richard Eaddy is the CEO and founder of Hedgebook and the Managing Director of ETOS Ltd, specialists in treasury outsourcing services. Richard has worked in the corporate treasury risk management industry for more than 20 years. He has held senior roles in large corporate treasury departments in both New Zealand and Europe, provided treasury risk management advice to major corporations and for the last ten years has headed up the largest treasury outsourcing company in Australasia. Richard can be contacted at richard.eaddy@myhedgebook.com.

When to use zero-premium FX collar options as the method of hedging

For importers and exporters managing trade-related transactional FX exposures, the choice of hedging instrument is just as important to overall performance as tactical/strategic risk management decisions to position at the minimum or maximum of hedging policy limits. Increased volatility in many currency pairs over recent years has naturally increased option premium costs, however it is not wise to always hedge via zero-premium collar options and never consider paying premium to buy outright call and put currency options. The choice between these option instruments and straight forward exchange contracts normally comes down to the following considerations:

  • If the home currency spot rate is at an historical low point against the export receipt currency (say based on long-term average rates) and the lead-indicators point to a greater probability of appreciation of the home currency than further depreciation, the choice of hedge instrument is going to be heavily weighted to straight forwards.
  • If the home currency spot rate is at an historical high point against the export receipt currency (based on long-term average rates) and the lead-indicators point to a greater probability of depreciation of the home currency than further appreciation, the choice of hedge instrument is more likely to be buying outright call options on the home currency.
  • When the currency pairs are trading closer to long-term average levels and there is no clear indication on future direction either way, collar options fulfill the objective of being hedged at an acceptable rate (the cap), however leaving some opportunity to participate in favorable market rate movements at least down to the collar floor level.

In some respect, hedging with collars is akin to having permanent orders in the market to deal at more favourable exchange rate levels with protection on the other side along the way. Whilst zero-premium may appear attractive, FX risk managers should always examine the trade-off’s of paying some premium to widen the gap between the floor and cap strike rates to provide greater opportunity of participation in favourable rate movements. In a similar vein, opportunities should be taken to restructure collars over the course of their term by buying back the sold cap or floor, or alternatively converting the collar to a straight forward if original target hedged rates are achievable. An active mixture of hedging instruments within policy limits should provide greater opportunity to beat benchmark and budget exchange rates.

Roger Kerr is widely regarded as one of New Zealand’s leading professional advisers and commentators on local/international financial markets, the New Zealand economy and corporate treasury risk management. Roger has over 30 years merchant and investment banking industry experience, and has been closely associated with the changes and development of New Zealand’s financial markets since 1981. Roger advises many Australian and New Zealand companies in the specialist areas of foreign exchange risk, interest rate and funding risk and treasury management policy/governance matters.

Roger has provided daily market and economic commentary on the 6.40am slot at radio station NewstalkZB since 1994.