When implementing a cash flow hedge program, a major consideration is whether or not to include time value components (premiums for options, forward points for forwards, etc.) within hedge relationships. Doing so is elective from an accounting perspective; however, there are real-world circumstances and consequences to consider when making the decision.
There is a common fear that including a time value component can result in hedge ineffectiveness, or at least drive a breakdown in effective relationships over time. This fear is founded in some cases, but including time value can also be a useful tool: The inclusion of a time value component can actually remove P&L noise throughout the life of the contract.
By excluding time value components, you essentially make the strike or spot rate your hedge rate. This choice makes it extremely clear to management what your hedge rate is – a valuable piece of information for some corporates in planning. Here, too, there is a tradeoff: A change in the value of that time value component will ping through income, generally ending up either in other income and expense or in the hedged line item(s). When small companies don’t mind this impact, as it’s generally taken “below the line” and forward points in this low interest rate environment can be quite small for forward contracts. Others hedging with options or exotic currencies like INR or BRL do mind, as the excluded amounts impacting the P&L can be large and often difficult to predict.
Companies consider many things when making this decision, including the type of derivative, currency pair, hedge timing and hedge philosophy. Some companies believe the time value component of the derivative is essentially a cost that should be included with the impact of the hedge on the hedged item as the “cost of hedging.” Others stress predictability of the top line, and exclude time value to improve predictability of results above the line. Still others prefer not to report ineffective amounts from the hedge relationship, and therefore exclude the time value component to minimize this result.
Finally, some companies have certain hedge relationships that necessitate excluding time value components in order to create an effective hedge relationship. This can be due to the timing of the hedged item relative to the hedge contract’s maturity.
What’s right when it comes to including/excluding time value components in cash flow hedge relationships? There is no “one size fits all” answer. However, by asking the right questions and working with experts, it is possible to consistently get it right.