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Hedge Accounting – Summary

  • The accounting treatment of call options prima facie will depend upon the intention with which the options are purchased: for hedging or speculation (nonhedging).
  • If the position is taken as a hedge against some other position, then the relevant accounting standards will be applicable and there are certain conditions that are to be fulfilled for the same.
  • Only long calls and long puts are eligible for hedge accounting, as written calls or puts limit the profitability while exposing the investor to unlimited risks and as such are not eligible for hedge accounting.
  • The standards require that the potential for gains should be at least equal to the potential for losses; this is known as a symmetrical risk-reward situation. For a written option the risk-reward is asymmetrical; hence, written options per se do not qualify for hedge accounting.
  • However, a combination of written options and certain other derivative instruments that results in a symmetrical risk-reward may qualify for hedge accounting.
  • To qualify for hedge accounting, either the upside and downside potential of the net position must be symmetrical or the upside potential must be greater than the downside potential.
  • Written options based on symmetry of the gain and loss potential of the combined hedged position qualify for hedge accounting as per the accounting standard.
  • If a written option is designated as hedging a recognized asset or liability, the combination of the hedged item and the written option provides at least as much potential for gains (as a result of a favorable change in the fair value of the combined instruments) as it does exposure to losses from an unfavorable change in their combined fair value.
  • Hedge accounting is not permitted for covered calls. This prohibition is also specifically mentioned in the standard itself.
  • It is permissible to separate the intrinsic value and time value of an option contract, designate as the hedging instrument only the change in intrinsic value of an option, and exclude change in its time value.
  • The accounting standards permit an entity to apply hedge accounting for a delta-neutral hedging strategy and other dynamic hedging strategies under which the quantity of the hedging instrument is constantly adjusted in order to maintain a desired hedge ratio.
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