“My company is considering including options in its cash flow hedge program. What is the impact of including v. excluding time value for cash flow hedge accounting?”
The value of an option is a combination of both time value and intrinsic value. When an ATM option is purchased, the premium paid is all time value (no intrinsic value exists). Conversely, when the option expires, any value at exercise is intrinsic and no time value exists. Between the purchase date and expiry date the fair value of the option is a combination of both time and intrinsic values. When the time value of an option is included for cash flow hedging, all effective changes in value of the instrument are deferred in OCI until the underlying transaction occurs. When time value is excluded, only changes in intrinsic value (when strike is a better rate than month end spot) are deferred in OCI until the underlying transaction occurs. Current changes in time value impact earnings (the company elects the geography of those impacts at designation).
At a high level, the difference between the cash flow hedge accounting rule sets is that when time value is excluded, there will be more activity in the income statement month-to-month over the life of the option, cumulatively equaling the original premium paid: alternatively, when including time value there will be less income statement activity incrementally but the option premium is recorded to the effective account, along with any intrinsic value when the hedged item occurs. Changes in accounting for option premiums are proposed in both the FASB and IASB exposure drafts. Both proposals are good news for options as hedge instruments.
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