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 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.

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.