Under FAS 133, the valuation of interim hedge positions, and in particular, the bifurcation of hedge valuation changes into effective and ineffective portions,1 will also be a major factor in determining the desirability of hedge products.

Companies will have to report ineffective hedge valuation changes in earnings throughout the life of hedges, with this interim earnings impact a major change from the currently used deferral and cost accrual accounting methods. The following will analyze the expanded set of factors for determining hedge product desirability, especially in relation to interim hedge marking, and examine some possibly attractive product choices.

Interim Earnings Volatility

The interim marking of hedge positions will cause changes in hedge valuations that do not exactly offset changes in the value of the underlying exposure to pass to earnings upon adoption of FAS 133. Forward points and option time values are expected to constitute the major portion of these "ineffective" hedge results. Forward points are a function of interest rate differentials while option time values are a function of spot levels, interest rate differentials and implied volatility.

In monograph #120,2 the impact on earnings volatility resulting from forward and option hedges under FAS 133 was calculated. Option hedges were shown to result in much greater earnings volatility than forward hedges for both long and short time periods for USD/DEM and USD/JPY.

Forward point changes (the focus under FAS 133) were shown to be somewhat more volatile than changes based on straight-line accrual (the most common current accounting method) for some time periods while other periods showed little difference between the two accounting measurement methods.

Market-derived option time value changes (the focus under FAS 133) were a level of magnitude higher than option value changes based on accrual (a popular current accounting method) in all cases. In other words, the market-derived revaluation of forward hedges are not expected to cause an appreciable earnings impact under FAS 133 while the market-derived revaluation of option hedges is expected to have large earnings impacts for many corporations.

Taking Hedge Term Into Account

Monograph #120 examined the interim marking of six month options. Real world exposures, however, cover a range of tenors from a couple of days to years. This section will examine the remarking volatility of options with longer initial terms.

The charts below reflect one year USD/DEM and USD/JPY options that were initially struck at the money on a forward basis (ATMF). They display the percentage change of the original premium at the first quarterly marking (change in time value divided by original premium - in case of an ATMF options, the original premium is equal to the initial time value).

As can be seen from the charts, a one year ATMF option can lose as much as 90% of its time value in the first quarter (however, it is quite possible that the same option can gain some time value in the subsequent quarter). On average, the one year options lose more than 50% of their initial time value in the first quarter. This change will be reflected in earnings in the interim reporting period. As the time horizon was extended to two years, the average loss in time value in the first quarter was approximately 40% of the initial time value.

A table that displays the quarterly remarking of ATMF options with a range of initial terms is shown below (the proportional time value changes are averaged for USD/DEM and USD/JPY options using monthly data from 1993 - 1998):

The data in the table reflect the significant front-weighting of average time value losses when examined on a periodic basis. Options with an original term of six months lose nearly three-fourth of their initial time value (TV) in the first remarking period while 2_ year options lose more than a third of TV in the first quarter.

This is primarily because time decay is the greatest for short-term options. One way to view the front-weighting effects on a range of option terms is against the time value changes that would occur if the initial TV were straight-lined (which also corresponds to a popular pre-FAS 133 accounting treatment of option premiums).

Straight-lining (S-L) the initial time values would cause a 50% decrease in value for six month options while 2_ year options would lose 10% on a straight-line basis. The net additional TV loss was 24% in both cases. For an intermediate term, a 1_ year option lost 44% from the remarking method against an S-L change of 17%, a difference of 27%.

Looking at the final revaluation periods yields the flip side of these results. Six month options lose 26% of TV on an average basis against an S-L change of 50% while two year options lose 2% in the final period against an S-L change of 10%.

These results reflect actual data and the results for specific time periods will vary. However the consistency of the larger time value losses in the earliest periods and smaller proportionate changes in the final periods across the data should provide a strong indication of the relative time value changes that can be expected.

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