Apples and Oranges: the Time Value Component of Options vs. Forwards

Currency hedgers have the choice of including or excluding time value in effectiveness testing when applying cash flow hedge accounting to derivatives hedging forecasted FX-denominated transactions.

Inclusion of time value will usually result in the deferral of more of the change in value of a hedging instrument in other comprehensive Income on the balance sheet and less P&L impact, but typically at a cost of increased complexity in hedge effectiveness assessment and measurement processes.

The time value component of an option is a different animal from the time value on a forward contract (also referred to as forward points). The choice to include time value of an option contract in effectiveness assessment can have large impacts on the effectiveness of a hedging strategy.

A regression test for a forward contract with time value included might involve a regression of the changes in market forward rates across different contract maturities (to reflect differences in timing on the hedge maturity and the hedged transaction recognition date). For most currencies, the change in forward rates is driven primarily by movements in spot rates, and effectiveness can be proven with forward contracts hedging transactions with quite different maturities, since the FX spot rate movement is usually the primary driver of changes in all forward rates, with changes in time value/forward points typically less leveraging to the overall value of the contract.

Hedgers should be aware that they will typically need more certainty around the expect timing of the hedged transactions, if time value is included in their effectiveness assessment methodology, in order to meet hedge effectiveness requirements.

With options, the time value component is more influenced by time to maturity (among other things), and can have much more impact on overall changes in contract value than the forward points of a forward contract. For this reason, when testing option hedges for effectiveness with time value included, the differences in timing between the hedge contract maturity and hedged transaction recognition date typically can’t exceed 1 month, under a regression based effectiveness testing methodology, in order to pass conventional effectiveness tests. So with options strategies, hedgers should be aware that they will typically need more certainty around the expect timing of the hedged transactions, if time value is included in their effectiveness assessment methodology, in order to meet hedge effectiveness requirements.