A written option requires the seller (writer) of the option to fulfill the obligation of the contract should the purchaser (holder) choose to exercise it. In return for providing that option to the holder, the writer receives a premium from the holder. For example, a written call option provides the purchaser of that option the right to call, or buy the commodity, financial or equity instrument at a price during or at a time specified in the contract. The writer would be required to honor that call. As a result, written options provide the writer with the possibility of unlimited loss, but limit any gain to the amount of the premium received. In other words, written options can have the opposite effect of what a hedge is intended to accomplish. Thus, they are generally not permitted to be used as hedging instruments.
However, there are circumstances when a written option may be a more cost-effective strategy for entities than using other instruments—for example, when used to hedge the call option feature in fixed-rate debt rather than issuing fixed-rate debt that is not callable. If a reporting entity wishes to use a written option as a hedging instrument, the instrument must pass the “written option test.” The test includes a requirement to ensure that, when considering the written option in combination with the hedged item, the “upside” potential (for gains or favorable cash flows) is equal to or greater than the “downside” potential (for losses or unfavorable cash flows), as described in ASC 815-20-25-94
The written option test applies specifically to recognized assets, liabilities, or unrecognized firm commitments. As a result, we do not believe that a written option (or a net written option) can qualify as a hedging instrument in a hedge of a forecasted transaction.
If a written option is designated as hedging a recognized asset or liability or an unrecognized firm commitment (if a fair value hedge) or the variability in cash flows for a recognized asset or liability or an unrecognized firm commitment (if a cash flow hedge), the combination of the hedged item and the written option provides either of the following:
- At least as much potential for gains as a result of a favorable change in the fair value of the combined instruments (that is, the written option and the hedged item, such as an embedded purchased option)as exposure to losses from an unfavorable change in their combined fair value (if a fair value hedge)
- At least as much potential for favorable cash flows as exposure to unfavorable cash flows (if a cash flow hedge).
The combined position’s relative potential for gains and losses is only evaluated at hedge inception. It is based on the effect of a change in price, and the possibility for upside should be as great as the possibility of downside for all possible price changes.
Excluding time value from the written option test
allows a reporting entity to exclude the time value of a written option from the written option test, provided that the entity also specifies that it will base its assessment of effectiveness only on the changes in the option’s intrinsic value.
precludes hedge accounting for “covered call” strategies. In writing a covered call option, a reporting entity provides a counterparty with the option of purchasing an underlying (that the entity owns) at a certain strike price. In some cases, the reporting entity may then purchase an option to buy the same underlying at a higher strike price. A reporting entity may enter into this type of structure to generate proceeds by selling some, but not all, of the upside potential of the securities that it owns. Under such a strategy, the net written option does not qualify for hedge accounting because the potential gain is less than the potential loss.
Combination of options
Hedging strategies can include various combinations of instruments (e.g., forward contracts with written options, swaps with written caps, or combinations of one or more written and purchased options). A derivative that results from combining a written option and a non-option derivative is considered a written option. Reporting entities considering using a combination of instruments that include a written option as a hedging derivative should evaluate whether they have, in effect, a net written option, and therefore, are required to meet and document the results of the written option test.
outlines certain requirements for a combination of options to qualify as a net purchased option or zero-cost collar, in which case the written option test is not required.
For a combination of options in which the strike price and the notional amount in both the written component and the purchased option component remain constant over the life of the respective component, that combination of options would be considered a net purchased option or a zero cost collar (that is, the combination shall not be considered a net written option subject to the requirements of 815-20-25-94) provided all of the following conditions are met:
- No net premium is received.
- The components of the combination of options are based on the same underlying.
- The components of the combination of options have the same maturity date.
- The notional amount of the written option component is not greater than the notional amount of the purchased option component.
applies only when the strike price and the notional amount in both the written and purchased option components of a combination of options remain constant over the life of the respective components. If either or both the strike price or notional amounts change, the assessment to determine whether the combination of options is a written option is evaluated with respect to each date that either the strike price or the notional amount changes.
If a combination of options fails to meet all of the criteria in ASC 815-20-25-89
, it cannot be considered a net purchased option and is subject to the written option test. For example, if a collar includes a written floor based on the three-month Treasury rate and a purchased cap based on three-month LIBOR, the underlyings of the components are not the same, and therefore, the collar would be considered a net written option subject to the written option test.
A combination of options entered into contemporaneously is considered a written option if either at inception or over the life of the options a net premium is received in cash or as a favorable rate or other term. Further, a derivative that results from combining a written option and any other non-option derivative is a written option.
Under certain circumstances, a reporting entity that has combined two options might be able to satisfy the requirement that the hedge provides as much potential for gains as it does for losses. However, the entity would not be permitted to apply hedge accounting to the combined position unless it were to satisfy this requirement for all possible price changes.
Redesignation of a combination of options
When redesignating a hedging relationship involving a zero-cost collar or a combination of options that was considered a net purchased option, a reporting entity needs to re-assess whether the combination of options is a net purchased option or a net written option. The new assessment is based on the current fair values. For example, assume a reporting entity has a collar that at its inception was not considered a net written option and was designated in a hedging relationship. The reporting entity later dedesignates the original hedging relationship and wants to designate the existing collar in a new hedging relationship. In this situation, if the existing collar is deemed a net written option on the date of redesignation, the reporting entity would need to perform the written option test at the inception of the new hedging relationship based on the economics of the collar on that date.
Question DH 6-2
If a noncancellable swap with no embedded options has an initial value of $100,000, would it be considered a written option?
No. The $100,000 received at the initiation of the contract is not a premium received for a written option. The swap contract does not contain an option element. Rather, the initial value of $100,000 is an indication that the contract is off-market. The counterparty to the contract is paying for this initial value and expects to be repaid through future periodic settlements.
In essence, the swap contract contains a financing element. If it is more than insignificant, a reporting entity needs to consider ASC 815-10-45-11
through ASC 815-10-45-15
. If the $100,000 financing element is significant enough to disqualify the entire swap contract from meeting the definition of a derivative, then the contract should be accounted as a debt host and evaluated for whether it contains an embedded derivative that should be bifurcated (see DH 4
for a discussion of embedded derivatives).