Provides guaranteed rate protection while benefiting from any favourable movements in the exchange rate.

Zero Cost collar explained

A Zero Cost Collar provides the purchaser with a guaranteed protection of a specified ‘worst-case’ rate whilst also allowing them to benefit from any favourable movements in the exchange rate, up to a ‘best-case’ rate. No upfront premium is payable for this product. Should the purchaser require rates better than the ones currently available in the market then a premium payment is negotiable.

Zero Cost Collar Summary Table

Advantages Disadvantages

Guaranteed protection rate for 100% of your exposureUpside benefit is limited to that of the best-case rate

No premium is payable

Benefit from favourable currency moves up to the best-case rate

Select either the protected rate or the best-case rate

Potential credit requirement is less than a forward

How a Zero Cost Collar works in practice

Company ABC import goods from the US, and need to pay USD 1,000,000 in six months time to their supplier. The forward rate for six months is 1.5500.

The company need to protect themselves against adverse movements in the exchange rate, but would also like to benefit from any favourable exchange rate moves as this would help improve their profit margins. However, they are reluctant to pay a premium for this benefit.

The company informs us that they are prepared to accept a worst-case rate (or ‘protected rate’) of 1.5300. Based on this we allow them to participate in any favourable moves up to 1.6000 (the best-case rate). There is no premium payable for this Zero Cost Collar.

Possible outcomes at expiry:

Scenario 1

GBP/USD weakens and at maturity the exchange rate is 1.4300. The company exercises the right to buy USD 1,000,000 at 1.5300.

Scenario 2

GBP/USD strengthens and at maturity the exchange rate is 1.6600. In this case, the company will have to buy dollars at 1.6000, the agreed best rate that is nevertheless much better than the market rate at the time of dealing. Scenario 3 GBP/USD at maturity is between the best case and worst case rates. The company is free to purchase any amount at the prevailing spot rate.

Zero cost collar What is it?

A paper hedge agreement designed to keep your fuel prices within an agreed price range. Also

known as cap and floor. It requires no upfront payment. Here's an example of how it works

To begin, you and Global agree upon the fuel volume an appropriate price index (such as Platts) a hedging period of 3 months (you pay fluctuating spot market fuel prices) a maximum fuel price of $190 per tonne (the cap level) , and a minimum fuel price of $180 per tonne (the floor level).

Month 1

Average monthly price per tonne was $200 ($10 above the cap level)

Global pays you $10 per tonne at the end of the month. Month 2

The average monthly price per tonne was $185 i.e. within the collar range.

There is no settlement at the end of the month. Month 3

The average monthly price per tonne was $175 ($5 below the cap level)

You pay Global $5 per tonne at the end of the month.Result

$5 per tonne profit for you over the 3 month hedging period.

*At the end of each month, the amount paid (the settlement) was calculated on the difference between

the average daily Platts settle and the agreed cap and floor levels.

To recap

When the average monthly price settlesabove the cap level - Global pays you the difference at the end of the month below the floor level - you pay Global the difference at the end of the month between the floor and cap levels - there is no payment.

The pros and cons

Benefits

• Protection from price increases • Flexibility in physical supply

• No upfront premium

Disadvantages

• Opportunity loss when prices fall • Potential basis risk

• Margin calls

3 good reasons to use this strategy

Rising fuel prices would seriously undermine your business

You would like to benefit from falling prices after having fixed your maximum fuel prices

You would rather establish a floor level than pay an upfront cap premium.

Financial Times

Hedging Strategies for Oil Producers

Introduction

il producers operate in an environment subject to adverse price movement in the international oil market. This exposure to such risk is enough to increase a company’s costs or dramatically reduce its profits. As risk exposure reduces the producer’s appeal

to investors and makes gaining access to debt markets more difficult, the need to efficiently manage exposure to fluctuating commodity prices is clearly one of the greatest challenges facing an exploration and production company today.

In this presentation, we discuss several swap and option based strategies that oil producers can use to manage their market risk. All of these strategies can be structured for a variety of international crudes and products. Hedging periods and protection levels can be customized to fit any maturity and price level.

While the examples in this presentation are denominated in U.S. dollars, Sempra Energy Trading ® Corp. ("SET") can also offer hedging instruments in other major currencies.

Why Hedge?

Figures 1 & 2 show recent historical volatility of crude prices. As can be seen from these figures, forward crude prices are extremely difficult to predict and subject to rapid and significant change. A comparison of crude and heating oil historical volatilities with those of metals or financial assets shows that oil is one of the most volatile of all commodities.

Stake holders prefer companies that perform as planned

Hedging stabilizes cash flows 1. Reduces cost of capital 2. Secures company

objectives 3. Enables management to

measure performance

Doing nothing to manage risk is in itself a risky move.

Fixed for Floating SwapsParticipation SwapsSpread SwapsCaps and FloorsCollarsHybrid Strategies

Figure 1. WTI 20-Day Moving Average: 1996-2007

Figure 2. Average of 20-Day Historical Volatility (In Percent)

Fixed For Floating Swaps

Overview

fixed for floating swap is a privately negotiated, financially settled forward contract covering a series of forward pricing periods.

A swap is designed to transfer, or "swap,"specific price risk between the swap purchaser (e.g., the End User) and the swap provider (e.g., SET) through a contractual exchange of payments. It involves the payment of a fixed price times a notional amount by one party, in exchange for a floating price times the same notional amount from another party.

A swap enables oil end users to fix the purchase price of future oil consumption and thus minimize any exposure to rising prices. By locking in prices, producers gain greater control over the variable revenues and costs inherent in their businesses.

The financial settlement ensures that traditional customer (i.e., physical) relationships are not distributed.

There is no commission for a swap.

Specific Terms of Swap Agreements

Reference Price An agreed upon pricing source and calculation method to establish the current or floating price of the commodity.

Fixed Price The agreed upon price which is multiplied by the quantity of the commodity to calculate the size of the fixed payment.

Floating Price The Reference Price as calculated for a pricing period, which is multiplied by the quantity of the commodity to calculate the floating payment.

Swap Maturity The length of the swap contract, which may cover several pricing periods.

Pricing Periods A schedule of agreed upon forward time periods. At the end of each pricing period the floating price is evaluated, and the floating and fixed payments are exchanged. Monthly, quarterly and annual pricing periods are commonly used.

Reference Quantity The notional amount of the commodity used to determine the swap cash flows at the end of each pricing period.

Application

An Oil Producer of 300,000 bbl/month sells crude oil to its customers at an agreed-upon index

price. The firm wants more predictable cash flows in order to determine its ability to capitalize on exploration and production opportunities next year.

To help accomplish this objective, the Producer enters into a one-year swap with SET to hedge 1/3 of its production at a fixed price of $22.00/bbl. This swap hedge is financially equivalent to a forward sale of 100,000 barrels of crude oil per month for 12 months.

On each Settlement Date, the Producer receives from SET a fixed payment equal to $22.00/barrel.

The Producer, in exchange, makes a floating payment to SET based on the arithmetic average of the daily settlement prices of the prompt NYMEX crude oil futures contract for each of the Pricing Periods for which the Reference Price is quoted.

The floating payment paid to SET should closely approximate the payment received by the Producer from its customer(s) for physical deliveries of crude oil. The net result is that by combining the swap with its current physical crude oil contract, the Producer receives $22.00/bbl for its oil sales.

Sample Terms

Results

The table below shows the Swap transaction results, given different monthly average WTI prices.

Swap Results on a Settlement Date in US$/bbl (first 5 months)

Discussion

A Swap enables the Crude Oil Producer to fix the sale price for future periods. The Producer receives a positive pay-off from the swap if crude oil prices fall. However, the Producer faces opportunity cost under the transaction if crude oil prices rise.

Financial settlement ensures that the Producer can offset its SET swap transaction with transactions carried out with traditional customers.

Participation Swaps

Overview

he participation swap contract establishes a minimum average forward sale price, while offering between 25% -100% participation in upward price moves.

It is an attractive alternative to many other producer hedging strategies because it overcomes the problem of forfeited upside price movements in a conventional swap.

Because of the forward sale, the Producer achieves complete price protection from any decrease in oil prices. If prices rise instead, the Producer participates in the favorable price move at the participation rate once average prices rise above the forward sale level.

The participation swap strategy outperforms the basic swap if prices

rise sufficiently. It is most appropriate if strong upward price moves are expected, yet prices also seem vulnerable to sudden downward spikes.

Strategy

The Producer sells forward, establishing a minimum average sale price.

The participation swap price is set at a slight discount to the regular swap price.

In exchange for a lower forward price, the Producer receives the right to participate in favorable price moves above a specified participation price level at an agreed upon participation rate.

There is no up-front payment.

Sample Terms

Spread Swaps

Overview

pread swaps are designed to allow the Producer to lock in the differentials between commodity prices at different time periods (e.g., calendar swaps), or the price differentials between different commodities (e.g., crack swaps).

In a spread swap, the swap purchaser (e.g., the Producer) pays a pre-agreed fixed spread level in exchange for a floating spread level from the swap provider (e.g., SET). The transaction is usually financially settled.

Through the use of spread swap, the Producer achieves complete price protection from significant shifts in price differentials, without affecting its traditional physical customer relationships..

There is no commission for a spread swap.

Caps And Floors

Overview

aps and floors are options which provide the right, but not the obligation, to enter into a long or short position at a specified price.

Caps, also referred to as "call options," establish a maximum average purchase price for future oil consumption. They provide full protection from rising prices while allowing the buyer to benefit fully from decreases in oil prices. Caps are usually bought by oil end users.

Floors, also referred to as "put options," establish a minimum average sale price for future oil production. They provide full protection from falling prices while allowing the buyer to benefit fully from increases in oil prices. Floors are usually bought by oil producers.

The buyer of the cap or floor agrees to pay a predetermined cash premium for the protection. The premium varies with the selected strike price, term of the contract, and length of the averaging period.

Caps and floors are usually financially settled based on the average oil price over a specified period. While long dated maturities are available, monthly and quarterly averaging periods are the most popular.

Specific Terms of Cap/Floor Agreements

Call Option The right, but not the obligation, to buy a fixed quantity of a commodity, for a predetermined price, at a specific date in the future.

A Call option ensures a maximum price at which the commodity can be purchased.

Put Option The right, but not the obligation, to sell a fixed quantity of a commodity, for a predetermined price, at a specific date in the future. A Put option ensures a minimum price at which the commodity can be sold.

Premium The price the option buyer pays and the seller receives for the option.

Strike Price The predetermined price at which the commodity can be purchased or sold, if the option is exercised.

Expiration Date The date on which the option contract ends, and the option is either exercised or expires.

Volatility A measure of the price change of a commodity over a period of time.

Caps A Strip of call options with staggered expiration dates. A Cap ensures a maximum purchase price for several future periods.

Floors A Strip of put options with staggered expiration dates. A Floor ensures a minimum sales price for several future periods.

Averaging Period A predetermined time period ending with option expiration. The payoff of an APO's is determined by comparing the average commodity price over this period with the option strike price.

Application

An Oil Producer is exposed to highly volatile oil prices, which have significant impact on its cash flow and its ability to service its debt. In order to decrease the chance of default, the Producer’s banks and creditors require that the company protect itself against a significant drop in oil prices. Specifically, the Producer and its lenders have determined that oil prices below $20.00/bbl will severely hamper the company’s ability to service its debt.

In order to gain downside price protection, the Producer enters into a two-year $20.00/bbl strike floor agreement with SET for 100,000 bbl/month at a $1.25/bbl premium. The market price is based on averaging the daily prompt NYMEX crude oil futures contract settlement prices in each forward period over the contract term.

During the life of the agreement,

The Producer continues to sell 100,000 bbl/month of its oil production to its regular customers at agreed-upon index prices.

SET receives an upfront $1.25/bbl monthly premium for providing the price protection below $20.00/bbl.

The Producer receives the market price for oil, as long as the market price is above $20.00/bbl for a given month. If the market price falls below $20.00/bbl, SET pays the Producer the difference between the market price and the floor price.

Arranged in conjunction with the physical floating price sale, the floor agreement ensures that the oil sale price received by the Producer will never be less than $18.75/bbl (i.e., $20.00/bbl - premium of $1.25/bbl).

Risk-Reward Profile

Discussion

Floors offer the Oil Producer the opportunity to minimize exposure to unanticipated decrease in oil prices without any loss of participation in favorable price moves.

With cap and floor purchases, all risks are predefined; the maximum "cost" or "loss" incurred by the buyer will always be the up-front premium payment.

The financial downside risks of receiving less than $18.00/bbl for its oil are far greater than the cost of the oil price protection.

Collars

Overview

collar, also referred to as "min-max strategy," is a zero or low cost hedging strategy that assures the Oil Producer a minimum / maximum price range for future oil sales.

Under a collar contract, the minimum possible sale price is equal to the floor price and the maximum possible sale price is equal to the ceiling price. For prices within this range, the Producer achieves the market price.

The contract is normally financially settled and often covers several pricing periods.

There is usually no up-front premium payment. Under a standard zero cost collar contract, the Producer can specify either the "floor" or the "ceiling" price level. The other price level is calculated by SET to ensure a zero-premium expense. If the Producer wishes, it can specify both price levels, but then it may incur some premium expense or income.

The Producer gains complete price protection from any prices below the floor price. However, in exchange for zero up-front premiums, any benefit from an oil price increase above the ceiling price is foregone.

The collar is, in many ways, similar to a swap, but it allows for greater flexibility through some market responsiveness. The collar outperforms a swap strategy if prices increase.

Application

An independent Oil Producer with an annual production of 1.2 million barrels wants to protect 50% of its production from falling oil prices. However, it does not want to pay a cash premium for the protection, and also requires more flexibility than a standard swap can provide.

In order to achieve this objective, the Producer enters into a one-year WTI zero-cost collar agreement with SET for 50,000 bbls per month. Under the agreement, the Producer is protected with a floor price of $20.00/bbl. In exchange for this protection, the Producer agrees to limit its upside price potential with a price cap of $24.00/bbl.

During the life of the agreement,

The Producer continues to sell oil to its regular customers at the agreed upon index prices.

At the end of each month, if the monthly average WTI price is below the $20.00/bbl floor price level, the Producer receives a payment equal to the amount by which the average is below the floor price.

If the average WTI price is above the $24.00/bbl ceiling price level, the Producer is obligated to make a payment equal to the difference between the ceiling price and the average price.

If the average prices move within the floor/ceiling range, no payments are required under the contract and the Producer achieves the prevailing market prices.

Sample Terms

Risk-Reward Profile

Discussion

The collar assures that the Producer receive a fixed price range for crude oil sales at no monetary cost. The costless collar is partially "paid for" by giving up the potential favorable price movement above the ceiling.

The collar can be structured to match specific production characteristics.

Hybrid Strategies

Overview

ybrid strategies, sometimes called "hybrids," combine the basic building blocks of swaps and options to create highly structured financial products that oil producers can use to meet specific

hedging objectives.

Given the over-the-counter financial tools and the flexibility inherent in the oil end user’s physical system, hybrids can be used to address virtually any risk profile. It is possible to establish a hedging program at higher than market levels and/or to reduce the cost of option based strategies.

Hybrids can take on a variety of forms. The more common hybrid products include:

Extendable swaps Double-up or double-down swaps Participating collars Swap options (or "Swaptions") Cross-commodity indexed swaps Range swaps (or other instruments utilizing digital options) Extendable collars (or other applications of compound options) Barrier or "knock-out" options One time settlement options

Extendable Swaps

Extendable swaps are similar to fixed for floating swaps except that SET has the right to extend the contract maturity for a prespecified amount of time for the same Reference Quantity.

The advantage of the extendable swap is that the swap Fixed Price is higher than that of a conventional swap. For example, the Oil Producer enters into a one year extendable swap with SET. Whereas the swap Fixed Price for a comparable fixed for floating swap for the same contract maturity and Reference Quantity would be $22.00 per barrel, the swap Fixed Price for the extendable swap for the crude oil producer would be $22.50 per barrel.

If the prespecified contract extension is set for another year, the Producer will continue to sell prespecified quantities for the period at the same price if SET elects to extend the swap maturity.

Extendable Swaps: Sample Terms

Double-Up Swaps

A double-up swap is similar to a basic swap except that it offers the Oil Producer the opportunity to significantly improve its effective sale price.

Under a double-up swap, the Producer’s swap fixed price is set higher than for an otherwise identical conventional swap. In exchange, the Producer agrees to sell on any settlement date prespecified additional quantities of the commodity at the swap fixed price, if SET elects to buy these additional quantities.

The double-up swap is usually structured for financial settlement.

Participating Collars

Participating collars allow for index flexibility within a specified price range and provide a predetermined percentage gain from any favorable price moves.

Swap Options

Swap Options, or "Swaptions,"provide the right, but not the obligation, to buy or sell a swap at a predetermined fixed price, in exchange for a premium payment.

Cross-Commodity Indexed Swap

Cross-commodity indexed swaps allow the Oil Producer to synthetically shift revenues from one commodity to another to reduce price risk and volatility.

Range Swaps

In a range swap, the Oil Producer sells a swap at a level above the current market. However, the swap ceases to exist if the market settles below the pre-determined level in any individual month.

Application

A Producer sells a crude oil swap to SET at a fixed price of $23.00 (when the market price is $22.00).

If the market settles below $19.00/bbl in any month, the swap ceases to exist for that month, meaning that the Producer does not have a hedge.

Barrier or "Knock-Out" Options

Barrier options are similar to conventional options, except for the addition of a second expiration feature which makes them cheaper to purchase.

In addition to the usual option terms, an "out" price level is specified. If the commodity price is at or moves through the "out" price level, at any time during the life of the option, the option expires immediately. Otherwise, the Barrier option offers the same protection as a conventional option.

Sempra Energy Trading ® Corp. Profile

empra Energy Trading ® Corp. (SET), formerly AIG Trading Corporation, is a subsidiary of Sempra Energy, a San Diego-based Fortune 500 energy services holding company with the largest U.S. utility customer base. As of December 31, 1999, Sempra Energy

had an equity market value of US$4.2 billion, total assets of US$12 billion and total revenues of US$5.5 billion. Sempra Energy has a credit rating of "A."

Sempra Energy Trading ® Corp. trades financial and physical crude and petroleum products, natural gas, natural gas liquids and electricity as a principal in North America and Europe. SET is one of the largest physical and financial market-makers in the natural gas and power industry in the U.S. and Canada, and one of the leading traders of crude and petroleum products in North America and Europe.

Business Objectives :

SET was established to engage in hedging, trading and financing activities related to the energy and other commodities markets. Each of the SET trading departments includes a team of specialists who have extensive experience with trading, hedging, and corporate finance. SET offers a full array of products including spot, forwards, leases, swaps, options and other derivative products. Furthermore, SET's specialists will structure hedging and financing programs to meet the specific needs of each client.

The zero cost collar hedging strategy

By Upul Arunajith

The Ceylon Petroleum Corporation got into a ground breaking agreement with the Standard Chartered Bank earlier this year. The agreement was to provide upside price protection to the CPC from escalating crude oil price in a spot market. This agreement was a trailblazer initiative that introduced the concept of commodity hedging using Derivative instruments for the first time in Sri Lanka. By introducing hedging, the CPC created a precedent in Sri Lanka. However, despite having a hedge model in place to provide upside price protection the CPC had to increase the retail fuel prices in the recent months. Rationally, these recent price increases from a laymen’s analysis, potentially

disputes and questions the very validity of the hedging process.

Given due regards to the recent price revision, this article intends to discuss the validity of commodity hedging as it would apply as a measure introduced to guarantee price and provide protection in a volatile market.

Validity of the Price Guarantee Mechanism:The process of seeking price protection in a volatile spot market by taking an opposite position in the Derivatives market is known as Hedging. Hedging is an integral part of any operation that is sensitive to adverse movement in interest rates, foreign exchange rates, commodity prices (Agricultural / energy) and precious metal prices. In recent years, globally, all energy trading operations -- oil producers, refineries, airlines -- given the high oil prices introduced hedging as a measure to insulate from adverse commodity price movements/volatility.

Financial instruments referred to as Derivatives facilitate the hedging process. Derivative instruments can be exchange traded or that are traded over the counter between two counter parties. Futures and Options are Exchange traded while Over the Counter (OTC) Derivatives are customized trades. For the most part,

Success of a hedge model is contingent upon the selection of the - *Correct Instrument ( Futures, Options, and SWAPS)*Strategy ( Asian Option, Average Price Commodity SWAP).This article intends to take a closer look at the Zero Cost Collar strategy used by Standard Charted Bank to provide a price protection to the Ceylon Petroleum Corporation.

What is a Zero Cost Collar?“Zero Cost Collar” or a “Costless Collar” is an Option trading strategy that is used in the short term to seek protection from short term market volatility forecasts.

Transaction Basics: A Zero Cost Collar strategy combines the sale of a Put Option and the purchase of a Call Option. Put Option gives the holder the right to sell the underlying product ie. commodity at a strike price(capped price) that is pre determined. Call Option gives the holder the right to buy the underlying product at the strike price that is pre determined. In a situation where the protection seeker wants protection from increasing spot market prices, as illustrated above the Option premium collected by the sale of the Put Option with a lower strike price (capped sale price) will fund the purchase of a Call Option with a higher strike price(capped purchase price). For the most part, due to the inverse relationship between the strike price and the Option premium with a wide spread between the Put Option and the Call Option, the limited proceeds from the sale of the Put Option will only fund a Call Option with a relatively higher purchase price of the underlying commodity thereby compromising the potential benefits.

Zero Cost Collar, essentially creates a position of a “Synthetic Futures”. Futures contracts “locks & guarantees” the purchase / sale price for forward delivery. Extreme downside participation is given up for partial benefits from upside participation.

Effectively, the Zero Cost Collar will pay off once the spot market price exceeds the Call Option strike price (=call capped price). The Put Option will expire worthless. However, if the spot market price drops below the Put Option Strike price (=put caped price) the Zero Cost Collar strategy will not allow any

participation in the down side.

The above is an illustration of a Zero Cost Collar strategy. When the spot market price moves over and above the strike price of the Call Option, the Call Option will be exercised and the difference between the strike price and market price will be received by the Zero Cost Collar buyer. Meanwhile, if the spot market price is below the strike price of the Put Option, the Zero Cost Collar buyer cannot participate in the lower spot market price. As long as the spot market price moves between the Put option strike price and the Call Option strike price, there will be no pay backs. However, the moment, the spot market price moves beyond the Call Option strike price, the Call Option will pay back.

Over a long period of time, the sport market prices can move significantly. The price pendulum can move from one extreme to the other. Given the implied volatility of the spot market price movement, Zero Cost Collar is a strategy that will be effective only on the short term. If used on a long term basis, the benefits will be minimal since the strategy effectively creates a synthetic futures position due to the put option locking in the future delivery price even when the spot market price drops below the Put Option strike price.

There is a trade of in any situation. It is said that you get what you pay for. Zero Cost Collar is a protection seeking strategy virtually for free. This is akin to getting an auto insurance policy free without any premium payments. But how good is that policy going to be? Obviously, it will provide the policy holder the bear minimum. By the same token, a Zero Cost Collar while being a relatively cost effective process of seeking limited upside protection gives up the potential to participate in the downside price movement. Given the above matrix of the Zero Cost Collar structure, the better alternative to the Zero Cost Collar is a basic Call Option strategy that will provide upside protection for the upfront payment of a premium.

This strategy will allow the Call Option holder to participate in the downside of the market price movement. The Option premium is an investment and not be seen as an expense. As long as the Option Premium is perceived as an expense, potential benefits of the hedge will be compromised by not getting into hedging and seeking a price protection.

Derivatives Implementation Group

Statement 133 Implementation Issue No. E18

Title: Hedging—General: Designating a Zero-Cost Collar with Different Notional Amounts As a Hedging Instrument

Paragraph references: 20, 21

Date cleared by Board: March 21, 2001

Date posted to website: April 10, 2001

Date revision posted to website: December 10, 2001

(Revised November 21, 2001)

QUESTION

In a hedging relationship in which a collar that is comprised of a purchased option and a written option that have different notional amounts is designated as the hedging instrument and the hedge's effectiveness is assessed based on changes in the collar's intrinsic value, may the hedged item be specified as two different proportions of the same asset based on the upper and lower rate or price range of the asset referenced in the collar?

In Example 1 in the Background section, may Company A designate as the hedged risk the change in fair value of 1,000 shares of XYZ stock (100 percent of the portfolio) resulting from price changes below $100 per share and the change in fair value of 70 percent of each of the 1,000 shares in the portfolio resulting from price changes above $120 per share?

In Example 2 in the Background section, may Company B, whose functional currency is the U.S. dollar, designate as the hedged risk the variability in U.S. dollar-equivalent cash flows on FC100 million (100 percent of the forecasted foreign-currency-denominated purchase price of inventory) resulting from changes in the U.S. dollar-FC exchange rate above $0.885 per FC1 and the variability in U.S. dollar-equivalent cash flows on FC50 million (50 percent of the forecasted FC100 million purchase price of inventory) resulting from changes in the U.S. dollar-FC exchange rate below $0.80 per FC1?

BACKGROUND

Example 1-Equity Collar

During January 1999, Company A issued a $100,000 debt instrument at a fixed interest rate of 8 percent that contains an embedded combination of options. The combination of options is comprised of the following:

A purchased put option with a notional amount equal to 1,000 shares of XYZ stock and a strike price of $100 per share. The purchased put option provides Company A a return of $1,000 for each dollar that the price of XYZ stock falls below $100.

A written call option with a notional amount equal to 700 shares of XYZ stock and a strike price of $120 per share. The written call option obligates Company A to pay $700 for each dollar that the price of XYZ stock increases above $120.

Overall, the collar provides the investor with a potential gain equal to 70 percent of the share price of XYZ stock in excess of $120 per share at maturity and exposes the investor to a potential loss in principal to the extent that the share price of XYZ stock is below $100 per share at maturity. (For both options, the underlying is the same-the share market price of XYZ stock.)

Company A also has 1,000 shares of XYZ stock classified as available-for-sale. The current market value of XYZ stock at the debt issuance date is $100 per share. The debt issuance is intended to eliminate the risk of a decrease in the market value in Company A's investment in XYZ stock.

According to paragraph 50 of Statement 133, as amended by FASB Statement No. 137, Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date

of FASB Statement No. 133, at the initial adoption of Statement 133, Company A must separately account for the embedded derivative in its debt issuance. (The "grandfathering" provision related to embedded derivatives cannot be applied in this case.) Based on the guidance in Statement 133 Implementation Issue No. B15, "Separate Accounting for Multiple Derivative Features Embedded in a Single Hybrid Instrument," that embedded combination of options may not be separated into its components.

Statement 133 Implementation Issue No. E2, "Combinations of Options," includes the following criteria, which must be met in order for a combination of option contracts, including the combination of a single purchased option contract and a single written option contract, to result in a net purchased option or a zero-cost collar.

1. No net premium is received. 2. The components of the combination of options are based on the same underlying. 3. The components of the combination of options have the same maturity date. 4. The notional amount of the written option component is not greater than the notional

amount of the purchased option component.

Pursuant to the guidance in Implementation Issue E2, the combination of options should be accounted for as a net purchased option. As a result, if Company A chooses to use the combination of options as a hedging instrument, it is not required to comply with the provisions contained in paragraph 20(c) related to written options.

Upon adoption of Statement 133, Company A would like to designate the combination of options as a fair value hedge of its investment in XYZ stock. Assume Company A specifies in the hedge effectiveness documentation that the collar's time value would be excluded from the assessment of hedge effectiveness.

Example 2-Currency Collar

Company B forecasts that it will purchase inventory that will cost 100 million foreign currency (FC) units. Company B's functional currency is the U.S. dollar. To limit the variability in U.S. dollar-equivalent cash flows associated with changes in the U.S. dollar-FC exchange rate, Company B constructs a currency collar as follows:

A purchased call option providing Company B the right to purchase FC100 million at an exchange rate of $0.885 per FC1.

A written put option obligating Company B to purchase FC50 million at an exchange rate of $0.80 per FC1.

The purchased call option provides Company B with protection when the U.S. dollar-FC exchange rate increases above $0.885 per FC1. The written put option partially offsets the cost of the purchased call option and obligates Company B to give up some of the foreign currency gain related to the forecasted inventory purchase as the U.S. dollar-FC exchange rate decreases below $0.80 per FC1. (For both options, the underlying is the same-the U.S. dollar-FC exchange rate.) Assuming that a net premium was not received for the combination of options and all the other criteria in Implementation Issue E2 have been met, if Company B chooses to use the combination of options as a hedging instrument, it is not required to comply with the provisions contained in paragraph 20(c) related to written options.

Company B would like to designate the combination of options as a hedge of the variability in U.S. dollar-equivalent cash flows of its forecasted purchase of inventory denominated in FC. Assume Company B specifies in the hedge effectiveness documentation that the collar's time value would be excluded from the assessment of hedge effectiveness.

RESPONSE

Yes. In a hedging relationship in which a collar that is comprised of a purchased option and a written option that have different notional amounts is designated as the hedging instrument and the hedge's effectiveness is assessed based on changes in the collar's intrinsic value, the hedged item may be specified as two different proportions of the same asset referenced in the collar, based on the upper and lower price ranges specified in the two options that comprise the collar. (That is, the quantities of the asset designated as being hedged may be different based on those price ranges in which the collar's intrinsic value is other than zero.)

The application of the guidance in this issue is permitted only for collars that are a combination of a single written option and a single purchased option for which the underlying in both options is the same. The guidance in this issue may not be applied by analogy to other derivatives designated as hedging instruments.

While the quantities of the asset designated as being hedged may be different based on the upper and lower price ranges in the collar, the actual assets that are the subject of the hedging relationship may not change. The quantities that are designated as hedged for a specific price or rate change must be specified at the inception of the hedging relationship and may not be changed unless the hedging relationship is dedesignated and a new hedging relationship is redesignated. Since the hedge's effectiveness is based on changes in the collar's intrinsic value, the assessment of hedge effectiveness must compare the actual change in intrinsic value of the collar to the change in value of the pre-specified quantity of the hedged asset that occurred during the hedge period.

In Example 1 in the Background section, the hedging relationship involving the equity collar and the shares of XYZ stock owned by Company A qualifies for fair value hedge accounting. In that case, the hedged risk is changes in the overall fair value of the hedged item. The hedged item is expressed as 100 percent of 1,000 shares of XYZ stock for price changes below $100 per share and 70 percent of each of the same 1,000 shares of stock for price changes above $120 per share. Fair value hedge accounting will be applied for those changes in the underlying (market price of XYZ stock) that cause changes in the collar's intrinsic value (that is, decreases below $100 per share and increases above $120 per share). Since the hedge's effectiveness is based on changes in the collar's intrinsic value, hedge effectiveness must be assessed based on the actual price change of XYZ stock by comparing the change in intrinsic value of the collar to the change in fair value of the specified quantity of shares for those changes in the underlying.

In Example 2 in the Background section, the hedging relationship involving the currency collar designated as a hedge of the effect of fluctuations in the U.S. dollar-FC exchange rate qualifies for cash flow hedge accounting. In that example, the hedged risk is the risk of changes in U.S. dollar-equivalent cash flows attributable to foreign currency risk (specifically, the risk of fluctuations in the U.S. dollar-FC exchange rate). The foreign currency collar is hedging the variability in U.S. dollar-equivalent cash flows for 100 percent of the forecasted FC100 million purchase price of inventory for U.S. dollar-FC exchange rate

movements above $0.885 per FC1 and variability in U.S. dollar-equivalent cash flows for 50 percent of the forecasted FC100 million purchase price of inventory for U.S. dollar-FC exchange rate movements below $0.80 per FC1. Cash flow hedge accounting will be applied for those changes in the underlying (the U.S. dollar-FC exchange rate) that cause changes in the collar's intrinsic value (that is, changes below $0.8 per FC1 and above $0.885 per FC1). Since the hedge's effectiveness is based on changes in the collar's intrinsic value, hedge effectiveness must be assessed based on the actual exchange rate changes by comparing the change in intrinsic value of the collar to the change in the specified quantity of the forecasted transaction for those changes in the underlying.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.

IASB sessions

Financial instruments: hedge accounting

At this meeting the IASB continued its redeliberations on the exposure draft (ED) Hedge Accounting and discussed zero-cost

collars, accounting for fair value hedges and nominal components that are 'layers'.

Zero-cost collars

A 'zero-cost collar' is a combination of a purchased and a written option, one being a put and one being a call option, that at

inception has a net nil time value. The Board discussed whether the treatment of changes in the time value for zero-cost collars and

other options should be aligned (to the extent applicable).

The Board received feedback on the ED that many respondents think the accounting for the time value of options should also extend

to the time value of zero-cost collars. Those respondents were concerned that to do otherwise would result in arbitrary accounting

outcomes and artificial structuring incentives would arise.

The Board tentatively decided that the accounting treatment for changes in the time value of options and zero-cost collars should be

aligned, with 11 Board members supporting this decision, one against and one abstaining.

The Board will discuss what that treatment should be at a future meeting.

Accounting for fair value hedges

The Board discussed the mechanics of presenting fair value hedges. The discussion addressed three aspects:

Presentation in the statement of comprehensive income. Presentation in the statement of financial position. Linked presentation.

Presentation in the statement of comprehensive income

In the ED, the Board proposed that the gain or loss on the hedging instrument and the hedged item should be presented in other

comprehensive income (OCI) with the ineffective portion of the gain or loss presented in profit or loss. Although most respondents

supported of providing this type of information, many disagreed with the proposed location (in the statement of comprehensive

income). The main concerns were their perception that using OCI lacked a conceptual basis and also the additional number of line

items in the statement of comprehensive income.

The Board discussed this feedback and tentatively decided to retain the requirement in IAS 39 Financial Instruments: Recognition

and Measurement, which means that gains and losses from hedging instruments and hedged items for the hedged risk of a fair value

hedge are presented in profit or loss. However, in order to provide more transparency about hedging activities, the Board also

tentatively decided to require in the notes to the financial statements disclosure in one single note of the effects of fair value hedges

and cash flow hedges on profit or loss and OCI, respectively. That disclosure includes the gross gain or loss from the hedged item

and the hedging instrument as well hedge ineffectiveness. This decision was supported by 11 Board members with one against and

two abstaining.

Presentation in the statement of financial position

In the ED, the Board proposed that the gain or loss on the hedged item that is attributable to the hedged risk should be presented as a

separate line item in the statement of financial position. Most respondents supported the elimination of 'mixed measurements' (ie

part fair value and part cost-based) in the statement of financial position but many were concerned about the addition of several line

items to the statement and would prefer providing this information in the notes to the financial statements.

The Board discussed this feedback and tentatively decided to retain the requirements in IAS 39 (ie a direct adjustment of the hedged

item for the effects of fair value hedging), but with a requirement to disclose the fair value hedge adjustment in the notes. All Board

members present supported this decision.

Linked presentation

In the ED, the Board proposed that linked presentation not be allowed for fair value hedges. The majority of respondents agreed

with the Board's proposal not to allow linked presentation. Respondents felt that linked presentation should not be considered, but

only within the context of only hedge accounting.

The Board discussed this feedback and tentatively decided to retain the proposal not to allow linked presentation for fair value

hedges, subject to doing some further outreach. This decision was supported by 12 Board members with one against.

Nominal components-layers

In the ED, the Board proposed that:

a layer component of the nominal amount of an item would be eligible for designation as a hedged item. a layer component of a contract that includes a prepayment option would not be eligible as a hedged item in a fair

value hedge if the option's fair value is affected by changes in the hedged risk.

Respondents agreed with the proposal that a layer component of the nominal amount of an item should be eligible for designation as

a hedged item, but had mixed views on the proposals regarding contracts that include a prepayment option.

The Board discussed suggestions for changes to the proposals and tentatively decided:

to confirm the proposal to allow layer-based designation of a hedged item (when the item does not include a prepayment option whose fair value is affected by changes in the hedged risk). This decision was supported by all the Board members present.

that for partially prepayable items a layer-based designation of the hedged item should be allowed for those amounts that are not prepayable at the time of designation. This decision was supported by 12 Board members with one against.

that a designation of a layer as the hedged item should be allowed if it includes the effect of a related prepayment option when determining the change in fair value of the hedged item. This decision was supported by 11 Board members with two against.

not to differentiate written and purchased prepayment options for the purpose of the eligibility of layer-based designation of hedged items (ie to confirm the proposal in the ED, which does not make that differentiation). This decision was supported by all the Board members present.

The Board will next discuss hedge accounting at the meeting on 11 May 2011.