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Intrinsic Value Versus Full Value Hedge Accounting
Bob Jensen at Trinity University

Introduction

In 1998, the Financial Accounting Standards Board (FASB) in the U.S. issued an exceedingly complex FAS 133 standard entitled Accounting for Derivative Financial Instruments and Hedging Activities.  This was followed by a IAS 39 issued by the International Accounting Standards Board (IASB).  Other nations also issued similar standards.  There are some differences, but the differences in the standards are rather minor.  For a discussion of some of these differences, see  http://faculty.trinity.edu/rjensen/caseans/canada.htm 

IAS 133 can be downloaded free from http://www.fasb.org/pdf/fas133.pdf 
The FAS 138 and 149 amendments to FAS 133 can be downloaded from http://www.fasb.org/st/index.shtml 
IAS 39 was recently revised and can be purchased for a fee from http://www.iasb.org/ 

Bob Jensen's tutorials and cases for FAS 133 and IAS 39 are at http://faculty.trinity.edu/rjensen/caseans/000index.htm 

Technical terminology is defined and illustrated at http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm 

Because FAS 133 was such a complex standard to be applied to even more complex hedging situations, the FASB formed a FAS 133 body to help business firms and accounting firms.  This body is called the Derivatives Implementation Group (DIG) which fields questions raised in practice.  DIG answers are not officially authoritative, but for all practical purposes they are accepted guidelines when implementing FAS 133 and IAS 39.  DIG pronouncements are available at http://www.fasb.org/derivatives/ .  One of these pronouncements relevant to this document is the G20 pronouncement entitled FASB: Cash Flow Hedges: Assessing and Measuring the Effectiveness of an Option Used in a Cash Flow Hedge at http://www.fasb.org/derivatives/issueg20.shtml 

The common types of derivative financial instruments are futures contracts, forward contracts, swaps, purchased options, and written options.  These contracts or complicated variations of these contracts can be used for speculative or hedging purposes.  All must now be booked initially (usually at their zero cost except for options having initial premiums) and then adjusted to fair value (e.g., market-to-market) during the period between acquisition and expiration.  This makes them somewhat unique since the basis of accounting for other financial instruments is generally historical cost with some exceptions (e.g., see FAS 115).  

Complicated rules for hedge accounting allow firms to reduce earnings fluctuations when adjusting some derivatives for changes in fair value.  The derivatives eligible for hedge accounting relief must be qualified for hedge accounting under the rules of the standards.  The rules vary with both the type of hedge, e.g., cash flow hedge versus fair value hedge versus foreign currency (FX) hedge.  Rules also vary with the type of hedging instrument, e.g., a forward contract versus a purchased option versus a written option.

Firms are the most upset about the rules of accounting for purchased options used as hedges.  The main problem is that choice of these options for hedging give rise to greater earnings volatility than the choice of any other alternative derivative financial instrument to perform the same type of hedge.  The reason, however, is that the firms tend to assess hedge effectiveness of options differently than with most other derivative financial instruments hedges.

Readers can read some of the complaints and listen to audio complaints by accounting experts regarding the options accounting mess by going to http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm

In particular note listen to the following complaint by John Woods, former partner with Andersen who calls the accounting standard for options "just awful.":

• Options accounting "is just terrible under FAS 133"  John Woods Audio WOODS10.mp3  --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/WOODS10.mp3

Purposes of this Document

In this paper, an "option" will refer to a purchased option.  The term will not refer to a "written" option held by the person or company that "sells" the option to the purchaser.  Purchased options afford speculators opportunities for highly leveraged gains with potential losses never exceeding what was paid for the options.  Written options afford speculators highly leveraged gains and unbounded losses.  Both types of options can be used for hedging purposes.

When a purchased option used for hedging changes in value,  the booked change in value must be be bifurcated into that part of the change in value that is deemed a change in "intrinsic value" versus that part which is deemed "time value."  Purchased options have a contracted forward price called a strike price that allows the option holder to buy (in the case of a call option) or sell (in the case of a put option) at the strike price at a future point in time.  The term spot price applies to the current price of the underlying commodity of the option such as the current price of corn or the current interest rate index.  

This paper focuses on an complexities of  hedge accounting strategies using options versus most other alternatives.  The purpose of this paper is to question why time value is accounted for differently when the hedging instruments are options that must post changes in time value to current earnings.  

A broad purpose of this document is to delve into the theory of "intrinsic value."   Key questions are as follows: 

• What is intrinsic value and how does it differ for options relative to most other types of derivative financial instruments.
  

• Should intrinsic value hedge accounting only apply to options contracts or should it be extended in revised standards for all derivative instruments?
  

• Should full value hedge accounting be allowed for options when companies only assess hedge effectiveness based upon intrinsic value?

Derivative financial instrument value over time tends to converge on "intrinsic value" defined as the difference between the spot and forward prices on the expiration date of the contract.  Between inception and expiration of the contract, this value diverges from intrinsic value due to "time value" that is impacted by market uncertainty as to what the spot price will be at the future date on which the derivative contract expires.  

In the case of purchased options, intrinsic value is defined somewhat differently in the sense that it may only be positive or zero.  In other derivative contracts such as forward and futures contracts, it may be positive, zero, or negative.  This is why purchased options are the only instruments with bounded risk.  After they are purchased, their future values can never be negative.  They cannot lose more than the initial premium paid, but their value may collapse to zero over the course of the entire contract period.  Most other derivative contracts have lower initial premiums (usually zero premiums) but may have negative values as well as positive and zero values over time and when the contracts expire.  This makes them much more risky if their is any chance that the spot prices may fluctuate greatly.

When derivative instruments are used as hedges, they may be acquired in such a way that on the date of expiration, they are perfectly effective in eliminating price risk of the hedged item.  Forward, futures, options, and swaps can eliminate all cash flow risk of the following types of hedged items:

• Cash flow risk of forecasted transactions having unknown future purchase or sale prices such as prices equal to future spot prices. 
  

• Future value risk of firm commitments having known future purchase or sale prices that may differ from future spot prices.  

Both cash flow and future value hedges can be perfectly effective on the date the hedging instrument expires and hedged item forecasted transaction or firm commitment is transacted.

Even for perfectly effective hedges on the date of expiration, there can be risks of premature settlement of a derivative contract or premature sale of the contract at its current fair value prior to when it expires.  In general, when derivative financial instruments are adjusted to fair value (as required under newer accounting standards) prior to expiration, only hedge accounting treatment is allowed to the extent that the hedge is deemed effective on the date of the fair value adjustment.  

The problem is that hedging contracts that are deemed in advance to be perfectly effective on the date of expiration may not be perfectly effective if they are settled or sold prematurely.  Time value risks may intervene giving rise to possible cash flow gains or losses arising from premature settlements or sales of the derivative instrument.  Since derivative financial instruments must be adjusted to fair value even if there are no premature settlements or sales, the offsetting adjustment gains and losses must be partitioned between current earnings (to the extent of measured ineffectiveness of a hedge) and some other account (that varies with the type of hedge) that allows, under qualified hedge accounting, all or a portion of a change in the value of a derivative financial instrument to not make earnings fluctuate during the hedging period of a hedge that most likely will be a perfectly effective hedge on the date of expiration when time value is reduced to zero.  If no hedging is involved, all offsets are to current earnings.  Earnings fluctuations can be dampened only for qualified hedges and only then to the extent of hedging effectiveness prior to contract expiration (even though there can be no ineffectiveness on the date of expiration).

It is important to understand how options differ from most other types of hedges such as forward and futures contracts in basic ways that frequently confuse students trying to learn hedge accounting:

• Certainty of Time Value Loss at Expiration of a Purchased Option Hedge:  Option contract value converges on intrinsic value on the date the option expires.  Time value may fluctuate wildly, but for purchased options cannot be negative and eventually converges toward zero.  Values of other types of derivatives such as futures and forward contracts also converge on intrinsic value.  However, intrinsic value may only be be positive or zero for purchased options.  This might be viewed as one-sided risk hedging.  If the purchased option has zero intrinsic value on the date of expiration, the spot price has moved favorably relative to the forward (strike) price such that the hedged item may be purchased or sold with an opportunity gain but not a loss.  For example, if the hedged item is a forecasted purchase of one unit of Commodity X and the forward (strike) price of a call option is $125 on December 31, then the call option expires at zero value on December 31 if the spot price is $120.  The call option only hedged against the possibility that the spot price would rise above $125.  Conversely, a forward contract hedge having a forward price of $125 would have a negative intrinsic value of -$5.00 since the forward contract's value converges on the positive or negative intrinsic value.  This is a net $5.00 loss if the call option was a speculation.  If it was a cash flow hedge, however the loss of $5.00 on the option is offset by being able to purchase the hedged item for the $120 spot price on December 31 rather than having to pay the hedged $125 price. 
  
  What is known for certainty on January 1 when the option is purchased is that its time value loss will be the value (premium) paid for the option on that date.  Suppose the premium is $9.25 on January 1.  This must all be time value since options generally have no intrinsic value when they are purchased (except in rare cases when they are already "in-the-money" at the purchase date.)  The time value always shrinks to zero at expiration since there is no future for the option beyond the option's expiration date.  The initial premium is viewed as the price paid to sleep nights without worrying about cash flow or value risk of the hedged item.  It is known for certainty that the time value loss will be -$9.25=$0-$9.25.  The ultimate intrinsic value is unknown, but the entire intrinsic value is what hedges the purchase or sale price or value of the hedged item.
  
  

• Uncertainty of Time Value Gain or Loss Prior to Expiration of an  Option Hedge:   If an option is settled prematurely, the time value loss would be its full premium since all time value is lost when options are settled at any point in time.    However, it would be silly to settle for only its intrinsic value if the time value is positive in an amount exceeding the transactions cost of the sale of an unsettled option.  Suppose that on January 1, the value (premium) of an option is its $9.25 time value and the intrinsic value is $0.  Prior to expiration on December 31, suppose the intrinsic value changes from $0 to $2.25 on March 31, and the time value decreases from $9.25 to $7.50.  If the hedged item is purchased prematurely on March 31 for $127.25, and the hedging option is sold for $9.75 fair value, the intrinsic value portion of $2.25 has been perfectly effective in locking in the $125 forward (strike) price.  But the premature settlement results in the loss of -$1.75=$7.50-$9.25 in time value.  The net loss of selling the option prematurely on March 31 is -$0.50=$2.25-$1.75.  This loss can never exceed the purchase price of the option, but it can be unbounded in the case of other derivative instruments like forwards, futures, and swap contracts.
  
  Since the hedging instrument is a purchased option, the maximum (bounded)  interim sale loss is known for certainty to be the initial premium of $9.25.  Although the interim loss is uncertain but bounded at $9.25, the interim gain is unbounded.  This is what makes purchased options to buy (call) and item or sell (put) an item so popular with speculators.  Possible losses cannot exceed the price of the option whereas gains are unbounded.  Even when used as hedges, the possible gains from options are unbounded.  In the above example, suppose the time value of the option soared to $1,009.25 on March 31 even though the added intrinsic value was only $2.25.  The holder could purchase the commodity for $127.25 and view the intrinsic value of $2.25 as the hedge that locked in the $125 price if purchased on March 31.  By selling the option for $1,002.25 full value, the option holder now has the commodity at a price of $125 and a time value gain of $1,000.  Speculative options at interim points in time become somewhat like forward contracts since there are unbounded possible gains prior to expiration but unlike forward contracts that also have unbounded losses.  On the date of expiration, however, when the time value is zero there can be no time value gains or losses for any type of derivative contract since time value converges on zero at the date of expiration.
  
  

• Minimum value and Paragraph 63 of FAS 133
  The minimum value of an American option is zero or its intrinsic value since it can be exercised at any time.  The same cannot be said for a European option that has to be held to maturity.  If the underlying is the price of corn, then the minimum value of an option on corn is either zero or the current spot price of corn minus the discounted risk-free present value of the strike price.  In other words if the option cannot be exercised early, discount the present value of the strike price from the date of expiration and compare it with the current spot price.  If the difference is positive, this is the minimum value.  It can hypothetically be the minimum value of an American option, but in an efficient market the current price of an American option will not sell below its risk free present value.
  
  Of course the value may actually be greater due to volatility that adds value above the risk-free discount rate.  In other words, it is risk or volatility that adds value over and above a risk free alternative to investing.  However, it is possible but not all that common to exclude volatility from risk assessment as explained in Sub-paragraph b of Paragraph 63 of FAS 133 quoted below.

a. If the effectiveness of a hedge with an option contract is assessed based on changes in the option's intrinsic value, the change in the time value of the contract would be excluded from the assessment of hedge effectiveness.

b. If the effectiveness of a hedge with an option contract is assessed based on changes in the option's minimum value, that is, its intrinsic value plus the effect of discounting, the change in the volatility value of the contract would be excluded from the assessment of hedge effectiveness.

c. If the effectiveness of a hedge with a forward or futures contract is assessed based on changes in fair value attributable to changes in spot prices, the change in the fair value of the contract related to the changes in the difference between the spot price and the forward or futures price would be excluded from the assessment of hedge effectiveness.

The point here is that options are certain to be effective in hedging intrinsic value, but are uncertain in terms of hedging time value at all interim points of time prior to expiration.  As a result, accounting standards require that effectiveness for hedge accounting be tested at each point in time when options are adjusted to fair value carrying amounts in the books even though ultimate effectiveness is certain.  Potential gains from options are uncertain prior to expiration.  Potential gains or losses from other types of derivative contracts are uncertain both before expiration and on the date of expiration.

For a discussion on how to value options, go to http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#ValuationOptions 

In order to qualify for hedge accounting at any point where a hedging derivative is to be adjusted upward or downward to current value on the books (as required by new accounting standards), effectiveness prior to expiration is generally assessed on one of two criteria:

• Effectiveness tests based upon intrinsic value changes only.  
  Because time value is uncertain before expiration of an option, it is common in practice for firms to assess hedge effectiveness of purchased options on the basis of only intrinsic value.  See Paragraph 63(a) if FAS 133.  This generally assures that there will be some stabilization of earnings arising from hedge accounting for purchased options.  Intrinsic value is used much less often for other types of hedging instruments such as forward, futures, swaps, and written options.  There is less certainty of earnings stabilization since those instruments, unlike purchased options, can have negative as well as positive time value prior to expiration.  There are various examples in the standards where intrinsic value is used for effectiveness testing of options.  Note Example 7 beginning in Paragraph 93 and Example 9 beginning in Paragraph 162 of FAS 133.  In those instances, only the changes in intrinsic value are eligible for hedge accounting.  The changes in time value are charged to current earnings even when the hedges are perfectly effective in terms of intrinsic value.  Although standard setters have never provided examples of intrinsic value-based hedge accounting for anything other than purchased options, Bob Jensen provides illustrations of this type of hedge accounting for futures contracts the first two citations below.  He also provides illustrations for purchased options used as hedges using intrinsic value-based hedge accounting:
  

  • MarginWHEW Bank Case (interest rate profit hedging with 30 Eurodollar futures contracts)
    http://faculty.trinity.edu/rjensen/caseans/285case.htm
    The Excel spreadsheet is at http://faculty.trinity.edu/rjensen/caseans/xls/285wp/285wp.xls 
    
    
  • Margin OOPS Bank Case (interest rate profit hedging with 75 Eurodollar futures contracts)
    http://faculty.trinity.edu/rjensen/caseans/285case.htm
    You can access the MarginOOPS Bank Case with buttons at the bottom of the screen.
    The Excel spreadsheet is at http://faculty.trinity.edu/rjensen/caseans/xls/286wp/286wp.xls 
    
    
  • CapIT Corporation Case (interest rate caps with Eurodollar interest rate put options taken from the Wall Street Journal)
    http://faculty.trinity.edu/rjensen/caseans/ccase.htm
    The Excel spreadsheet is at http://faculty.trinity.edu/rjensen/caseans/xls/283wp/283wp.xls 

    FloorIT Bank Case (interest rate floors with Eurodollar interest rate call options taken from the Wall Street Journal)
    http://faculty.trinity.edu/rjensen/caseans/ccase.htm
    You can access the FloorIT Bank Case with buttons at the bottom of the screen.
    The Excel spreadsheet is at http://faculty.trinity.edu/rjensen/caseans/xls/284wp/284wp.xls 

Readers interested in Example 9 from Appendix B of FAS 133 may want to download the Excel workbook 133ex09a.xls from http://www.cs.trinity.edu/~rjensen/ 

• Effectiveness tests based upon minimum value changes.
  When the derivative hedging instrument is an option and hedge effectiveness is stated initially to be based upon changes in an option's minimum value (intrinsic value adjusted for discounting), the volatility of the option may be excluded from effectiveness tests.  The minimum value model, as opposed to other valuation models like the Black-Scholes model, is based on one’s willingness to buy an at-the-money shout option on a share of stock with the right to defer payment of the exercise price until the end of the option’s term. The model has the advantage of simplicity but does not capture the effect of share price volatility.  A shout option is an option where the holder has the right to lock in a minimum value for the payoff at one (shout) time during the option's life. The minimum value is the option's intrinsic value at the shout time. 
  
  

• Effectiveness tests based upon full value changes.
  This is common with most hedging derivatives except for purchased options, but changes in spot prices can be initially declared as the basis for hedging under Paragraph 63(c) of FAS 133.  The illustrations in FAS 133 and IAS 39 implicitly assume full value hedging except in the case of purchased options.  There was some confusion about whether options effectiveness could be assessed on the basis of full value, but this was made certain in the DIG's G20 pronouncement entitled FASB: Cash Flow Hedges: Assessing and Measuring the Effectiveness of an Option Used in a Cash Flow Hedge at http://www.fasb.org/derivatives/issueg20.shtml 
  A passages from G20 are quoted below:
  

At the onset of each cash flow hedging relationship, an entity must document how it will assess effectiveness, such as whether the assessment will be based on total changes in the option's cash flows (that is, the assessment will include the hedging instrument's entire change in fair value—its entire gain or loss) as discussed in paragraph 63 of Statement 133, rather than based, for example, on only the changes in the hedging instrument's intrinsic value. The documented method must be applied consistently when assessing effectiveness throughout the hedging relationship. An entity's focus on the hedging instrument's terminal value is not an impediment to the entity's subsequently deciding to dedesignate that cash flow hedge prior to the occurrence of the hedged transaction. (Refer to paragraph 494 of Statement 133 for potential consequences when an entity determines the original hedged transaction probably will not occur.)

 

Dynamic Hedging Strategy Exception in IAS 39

FAS 133 allows choice of either intrinsic value effectiveness testing or full value effectiveness testing according to the DIG's G20 guidelines summarized and quoted above.  IAS 39 allows intrinsic value or full value effectiveness testing under a dynamic hedging strategy.  Paragraph 144 of IAS 39 reads as follows:

144. There is normally a single fair value measure for a hedging instrument in its entirety, and the factors that cause changes in fair value are co-dependent. Thus a hedging relationship is designated by an enterprise for a hedging instrument in its entirety. The only exceptions permitted are (a) splitting the intrinsic value and the time value of an option and designating only the change in the intrinsic value of an option as the hedging instrument, while the remaining component of the option (its time value) is excluded and (b) splitting the interest element and the spot price on a forward. Those exceptions recognize that the intrinsic value of the option and the premium on the forward generally can be measured separately. A dynamic hedging strategy that assesses both the intrinsic and the time value of an option can qualify for hedge accounting.

The Dictionary of Financial Risk Management defines dynamic hedging as follows --- http://snipurl.com/DynamicHedging 

Dynamic Hedging: 
A technique of portfolio insurance or position risk management in which an option-like return pattern is created by increasing or reducing the position in the underlying (or forwards, futures or short-term options in the underlying) to simulate the Delta change in value of an option position. For example, a short stock futures index position may be increased or decreased to create a synthetic put on a portfolio, producing a portfolio insurance-type return pattern. Dynamic hedging relies on liquid and reasonably continuous markets with low to moderate transaction costs. See Continuous Markets, Delta Hedge, Delta/Gamma Hedge, Portfolio Insurance.

 

Hedge Accounting Rules for Purchased Options

The term "intrinsic value" is based upon the difference between the forward price and the spot price.  In the case of a purchased call option, the option is said to be "in-the-money" whenever the spot price is lower than the forward (strike) price.  In the case of a purchased put option, the option is said to be "in-the-money" whenever the spot price is higher than the forward (strike) price.   Intrinsic value is the amount by which the option is "in-the-money."  A purchased option that has zero intrinsic value when it expires is worthless at the time of expiration.  It may not have been worthless before it expired since market traders may have given it positive "time value" in anticipation that it might have intrinsic value before it expires.  Initially at the date of purchase, the value (premium) of the option is entirely time value.  At the date of expiration time value is zero.  Between the date of purchase and the date of expiration of the option, the option value is the sum of intrinsic and time value components.  Some options never attain any intrinsic value and eventually expire worthless.  Options that have intrinsic value before expiration may gain or lose intrinsic value before expiration depending upon the movements of the spot price over time.

Current accounting rules stipulate that whenever the change in total current value of a speculative option is to be booked, the offsetting debit or credit must be to a current earnings account that is closed to retained earnings.  If the option is a hedge, the change in value must also be charged to current earnings except when the hedge qualifies for hedge accounting under strict rules of hedge accounting standards.  If it qualifies for hedge accounting, then the following rules apply:

• The change in time value of a qualified hedge must be charged to current earnings.

• The change intrinsic value of a qualified hedge may be accounted for in some way that avoids a charge to current earnings.  How this is accomplished varies with the type of hedge (e.g., cash flow versus fair value hedges) and whether the hedged item is booked (e.g., inventory on hand) versus an unbooked forecasted transaction or firm commitment.  Under the standards, an unbooked forecasted transaction must have a known amount (e.g., a forecasted purchase of 25,000 bushels of corn) but not a known purchase price.  A firm commitment has a contacted future price as well.

Most firms seek to have option hedges, along with all other types of hedges, qualify for hedge accounting.  However, because they traditionally assess hedge effectiveness based upon changes in intrinsic value rather than full value of options, they cannot get hedge accounting treatment for changes in the time value of the options.  This is less of a problem in other types of hedges where hedge effectiveness is based upon changes in the full value of the hedging instrument.

Intrinsic Value Versus Time Value When Accounting for Options

 For a discussion on how to value options, go to http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#ValuationOptions 

A forecasted transaction must have a specified date, notional amount, and unknown price to qualify as a hedged item.  Consider a forecasted transaction to purchase one unit of Commodity X on December 31. This conforms to Example 9 beginning in Paragraph 162 of FAS 133. On January 1, XYZ Company pays $9.25 for a call option for one unit of Commodity X with a forward (strike) price of $125.  The option's price (premium) of $9,25 on January 1  is all time value with zero intrinsic value on January 1.  Assume the spot price on March 31 (end of Quarter 1) rises to $127.25 and the call option  value rises to $9.75 with a $7.50 time value component and a $2.25 intrinsic value equal to the excess of the spot price over the forward (strike) price.

The option hedge ends all cash flow risk and is perfectly effective in locking in a $125 price in advance provided the option holder does not purchase Commodity X or settle the option before it expires on December 31 (the end of Quarter 4).  The option holder may make a speculative gain or loss if the option is net settled for cash prematurely.  Suppose the option holder prematurely purchases Commodity X on March for $127.25 per unit.  Further suppose that the value of the unexpired option on March 31 is comprised on $2.25 intrinsic value and $7.50 time value.  The intrinsic value of $2.25 effectively hedges the locked in $125 price ($127.25-$2.25).  

The time value provides a speculative bonus $7.50 time value that is lost if option is an American option that is settled prematurely on March 31.  To realize the time value prematurely, the option holder must sell the option for full value rather than settle the option prematurely.    A European option does not allow early settlement, but the option holder might accomplish the same purpose by selling the European option on March 31 at its full value.  There may be a difference in transactions cost, however, between prematurely settling an option versus selling an option at full value..

Now consider Example 9 beginning in Paragraph 162 of FAS 133.  Commodity X is not purchased until December 31 and the call option is held to its December 31 expiration date as a hedge that locks in the$125 purchase price.  The firm adjusted the option's value at the end of each quarter.  Changes in time value were posted to current earnings and changes in intrinsic value were posted to OCI at the end of each quarter.  All speculative gains and losses in booked time values wash away if the option is held to expiration date.  All interim OCI postings due intrinsic value changes add up to the final $5.75 OCI balance equal to the December 31 spot price of $130.75 minus the forward (strike) price of $125.  If there was no intrinsic value when the option expires, the OCI balance would have been zero.

The point is that it is certain that time value will become zero on the date the option expires.  However, the change in time value is speculative prior to expiration of the option  If the loss or gain is not captured before the option expires, there is no ultimate time value gain or loss.  The known (certain) facts are that the time value will be zero when the option expires and that the buyer will never have to pay more than the forward (strike) price on the date the option expires.  If the intrinsic value is less than the spot price on the date of expiration, then the buyer can buy the commodity for less than the forward (strike) price even though the option itself must then have zero value on the date of expiration.  If the intrinsic value is greater than zero when the option expires, then the intrinsic value realized is perfectly effective in offsetting whatever they buyer pays above the forward (strike) price for the commodity.  If the option is settled prior to expiration, then there can be speculative gains and losses due to changes in time value.

Hedge Accounting Rules for the Ineffective Portion of Hedge

The standards repeatedly state that only the "effective" portion of a cash hedge can be offset to something other than current earnings.  The "ineffective" portion must be offset to current earnings whenever derivatives that qualify for hedge accounting are adjusted to fair value before they expire.  The offset is OCI for the effective portion of a cash flow hedge.  Other types of hedges such as fair value hedges and FX hedges similarly provide hedge accounting relief only for the effective portion of a hedge.  Ineffective portions of the change in value of the hedging derivative are charged directly to current earnings.  

This begs the question of whether changes in time value are considered part of the "ineffectiveness" of a hedge.  Prior to expiration of a derivative financial instrument, the time value portion of its value changes are based upon market speculations subject to prediction error.  However, ineffectiveness and time value are different things in the accounting standards.

Actually, the standards do not allow hedge accounting for time value only if hedge effectiveness tests are based only upon intrinsic value.  Paragraphs 30(a) and  389 of FAS 133 read as follows

a. If an entity's defined risk management strategy for a particular hedging relationship excludes a specific component of the gain or loss, or related cash flows, on the hedging derivative from the assessment of hedge effectiveness (as discussed in paragraph 63 in Section 2 of Appendix A), that excluded component of the gain or loss shall be recognized currently in earnings. For example, if the effectiveness of a hedge with an option contract is assessed based on changes in the option's intrinsic value, the changes in the option's time value would be recognized in earnings. Time value is equal to the fair value of the option less its intrinsic value.

389. The Board attempted to develop a workable effectiveness test that would appropriately deal with the variety of risk management objectives and strategies that exist in practice. It ultimately decided to remove the specific effectiveness tests and, instead, to require that a hedge be expected to be highly effective in achieving offsetting changes in either fair value or cash flows, consistent with an entity's documented risk management objectives and strategy. The Board intends "highly effective" to be essentially the same as the notion of "high correlation" in Statement 80.

Companies can get hedge accounting for the time value of an option can get hedge accounting treatment for an option if they are willing to assess hedge effectiveness on the basis of both total value of the option rather than just changes in intrinsic value.  Note very carefully the wording in Paragraph 162 of Example 9 in FAS 133:

162. This example illustrates application of the accounting guidance for cash flow hedges described in paragraph 30 of this Statement. At the beginning of period 1, XYZ Company purchases for $9.25 an at-the-money call option on 1 unit of Commodity X with a strike price of $125.00 to hedge a purchase of 1 unit of that commodity projected to occur early in period 5. XYZ's documented policy is to assess hedge effectiveness by comparing changes in cash flows on the hedged transaction (based on changes in the spot price) with changes in the option contract's intrinsic value. Because the hedging instrument is a purchased call option, its intrinsic value cannot be less than zero.

Presumably, XYZ Company could get hedge accounting treatment for the time value of this option if the company was willing to assess hedge effectiveness based upon changes in the total option value rather than only the intrinsic value.

Why Is Intrinsic Value Effectiveness Testing Popular for Options

It's only possible to guess why something is popular less popular in practice.  In theory, however, possible reasons can be surmised why hedge effectiveness tests based on full value changes are less popular for purchased options than for other types of hedging derivatives.  One possible reason is that companies tend to use what is called "Delta hedging" with options.  Delta hedging itself is based upon full value comparisons of the hedging options and the hedged item's price (underlying).  Delta is mathematically equal to the first difference derived by the change in the option's value divided by the change in the hedged item's value.  A Delta-hedge position is constructed by by entering into a short (long) position in each option matched by a long (short) position in Delta units of the underlying assuming that the option's value can be approximated by Delta times the change in the underlying price.  Relatively small changes in the underlying generally result in a relatively constant Delta.  When the underlying's price changes are relatively large or the Delta hedge is not adjusted over time, the hedge becomes less effective.  An instability in Delta creates what is called a Gamma Effect instability of Delta relative to changes in value of the hedged item.  

Under hedge accounting rules, Gamma Effects may easily make it so that hedge accounting is not allowed for any part of the change in the value of the option if effectiveness tests are based upon full value.  When effectiveness tests are based only upon intrinsic value, there is much greater assurance that some portion of the option's change in value will be eligible for hedge accounting.

You can read more about Delta and Gamma at http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#D-Terms 

Although it is not explicitly stated in the standards, a rule of thumb for judging whether a change in an option's value is eligible for hedge accounting, is the 80%-125% Delta rule that states that hedge accounting can be used only when the Delta for a give period is greater than 80% and less than 100%.  A perfect hedge is one with a Delta of 100%.  

The FASB did not conduct effectiveness tests in Example 9 beginning in Paragraph 162 of FAS 133.  However, the example specifically assumes that the cash flow hedges are sufficiently effective based upon changes in intrinsic value.  In other words, the FASB assumed intrinsic-value based effectiveness testing in Example 9.  The hedge was assumed effective each period with changes in intrinsic value being eligible for hedge accounting (and charged to OCI) while changes in time value were not eligible (and charged to current earnings).  

We will now analyze what would have happened in Example 9 if effectiveness tests were based upon full value rather than intrinsic value.  A forecasted transaction must have a specified date, notional amount, and unknown price to qualify as a hedged item.  Consider a forecasted transaction to purchase one unit of Commodity X on December 31.  On January 1, XYZ Company pays zero for a forward contract to purchase one unit of Commodity X with a forward price of $125.  The premium of zero such that there is no intrinsic or time value on January 1.  Suppose the (underlying) spot price on March 31 (end of Quarter 1) rises to $127.25 and the forward contract value rises to $9.75 with a negative $7.50 time value component and a $2.25 intrinsic value component.

 Assume the firm adjusts the forward contract's value at the end of each quarter.  On March 31 and at all later dates in Example 9, the call option is perfectly effective with respect to intrinsic value.  Time value has declined from $9.75 on January 1 to $7.50 on March 31.  On the other hand, the option change in value has been highly ineffective in hedging the change in the spot value of Commodity X.  Hedge effectiveness is often measured in terms of Delta ratios based upon the change in the value of the hedging instrument divided by the change in value of the hedged item.  Suppose the spot price of Commodity X was $129.50 on January 1 and $127.50 on March 31.   In this example the Delta ratio is 25% derived from the absolute value of ($9.75-$9.25)/($127.50-$129.50).  

A Delta ratio of 25% indicates high hedge ineffectiveness of the total value change of the call option.  A common rule of thumb is the famous 80%-125% test that judges a hedge to be effective if Delta is greater than 80% and less than 125%.  On The 25% Delta test based upon the option's full value is highly ineffective.  Accordingly, hedge accounting standards would allow no hedge accounting on March 31 if effectiveness was based upon the change in full option value.  Using only intrinsic value for effectiveness testing, there is hedge accounting allowed for the full $2.25 change in intrinsic value on March 31.

Journal entries under the two alternatives are shown below::

Using the above outcomes illustrated in Example 7, there is more earnings volatility with intrinsic value effectiveness testing than full value effectiveness testing.  However, suppose that the March 31 option value jumped to $109.25 instead of $9.75.   Further assume that the underlying spot price jumped to $240 relative to the strike price of $150 resulting in a change in intrinsic value of $90=$240-$150.  The resulting earnings volatility is much greater for when management opts for full value effectiveness testing.  

If management seeks to reduce reported earnings volatility, the above outcomes favor full value effectiveness testing when the changes in option value are highly correlated with changes in hedged item value.  They favor intrinsic value effectiveness testing when there is lower correlation.  Since option holders frequently perform "dynamic" hedging to reduce Gamma Effects, it would seem that full value effectiveness testing is preferable with successful dynamic hedging.

Readers interested in the complete Example 9 from Appendix B of FAS 133 may want to download the Excel workbook 133ex09a.xls from http://www.cs.trinity.edu/~rjensen/ 

Conclusion?

Business firms have a fuss over "how awful" the hedge accounting rules are when options are used to hedge cash flows or fair value.  The rules are quite flexible in allowing for full value effectiveness testing when correlations between changes in option values are expected to be highly correlated with changes in value of the hedged item.  If lower correlations are expected, firms can choose to use intrinsic value effectiveness testing in an effort to achieve hedge accounting that causes less volatility in earnings.

This begs the question of why intrinsic value effectiveness testing is not popular for derivative instruments other than purchased options.  This is an interesting research question that has not been answered in the context of the newer hedge accounting rules.  One reason is that companies expect changes in option values to be somewhat less correlated with hedged item value changes than changes in values of forward, futures, and swap hedging instruments.