Illustration from KPMG's Derivatives and Hedging Handbook (now out of print).
Example Number = 4.14
Paragraph Number = 23.03
Page Numbers = 128, 129, 130, 131

Example 4.14--Hedge of an Available-For-Sale Security with a Put Option

For simplicity, the impact of commissions and other transaction costs, initial margin, and income taxes have been ignored.

Company A owns 1,000,000 shares of Company B's publicly traded stock.  As of January 1, 20X1, these shares are trading at $50 per share and Company A has an unrealized gain of $2,000,000 in AOCI associated with them.  Company A wants to lock in its unrealized gain.  Thus, Company A purchases a put option on Company B's stock from Bank C for $200,000.  The purchased put option allows Company A to put its 1,000,000 shares of Company B stock to Bank C at $50 per share at December 31, 20X1.  The purchased put option has been designated as a hedge of the exposure to a decline in the fair value of Company A's investment in Company B.

Assumptions:

  • Company A will assess effectiveness of the hedge by comparing changes in the intrinsic value of the put option with changes in the fair value of Company B's shares.  Because the option provides only one-sided protection, effectiveness only is required to be assessed during those periods the put option has an intrinsic value.
  • Given that the critical factor for this option is 1,000,000 shares of Company B stock, Company A concluded that the changes in the intrinsic value of the option will be highly effective (100 percent effective) at offsetting the changes in the fair value of its investment in 1,000,000 shares of Company B.
  • Because changes in the time value of the option have been excluded from the assessment of the hedges effectiveness, changes in these amounts should be included in earnings each reporting period.
  • All criteria for hedge accounting have been met.
  • Company A prepares financial reports at the end of every quarter.
  • Company A sold its investment in Company B at December 31, 20X1.
  • Company A accounts for its investment in Company B as available-for-sale securities pursuant to SFAS 115.
  • The share price and fair value of Company A's investment in Company B were as follows:

      Share Price Fair Value
    January 1, 20X1
    March 31, 20X1
    June 30, 20X1
    September 30, 20X1
    December 31, 20X1    		 $50
      60
      45
      40
      30    		 $50,000,000
      60,000,000
      45,000,000
      40,000,000
      30,000,000


  • The fair value, intrinsic value, and time value of the put option were as follows:

      (A)
    Fair Value    		 (B)
    Intrinsic Value    		 (A) - (B)
    Time Value
    January 1, 20X1
    March 31, 20X1
    June 30, 20X1
    September 30, 20X1
    December 31, 20X1    		 $      200,000
            180,000
        5,150,000
      10,050,000
      20,000,000    		 $              --
                    --
        5,000,000
      10,000,000
      20,000,000    		 $200,000
      180,000
      150,000
        50,000
               --

 

 

 

The following journal entries would be made by Company A at January 1, March 31, June 30, September 30, and December 31, 20X1.

The journal entry made at January, 20X1 would be as follows:

1.  Dr. Purchased put option (B/S)
     Cr.  Cash (B/S)
(To record the purchased put option in the statement of financial position at fair value)

The journal entries made at March 31, 20X1 would be as follows:

1.  Dr.  Change in fair value of the time value portion of the put option (P&L)
     Cr.  Purchased put option (B/S)
(To record the change in the time value portion of the put option)

2.  Dr.  Investment in Company B (B/S)
     Cr.  OCI
(To record the increase in fair value of the investment in Company B in OCI; note that there was no change in the intrinsic value of the put option)

The journal entries made at June 30, 20X1 would be as follows:

1.  Dr.  Change in fair value of the time value portion of the put option (P&L)
     Cr.  Purchased put option (B/S)
(To record the change in the time value portion of the put option)

2.  Dr.  Purchased put option (B/S)
     Cr.  Unrealized gain on put option (P&L)
(To record the change in the intrinsic value of the purchased put option)

3.  Dr.  OCI
     Dr.  Unrealized loss on Investment in Company B (P&L)
     Cr.  Investment in Company B (B/S)
(To record the change in fair value of the investment in Company B.  Note that the loss on this investment that is recognized in earnings is limited to the change in the put option's intrinsic value (i.e., the hedged risk).  The remainder of the change in fair value is recorded in OCI).

The journal entries made at September 30, 20X1 would be as follows:

1.  Dr.  Change in fair value of the time value portion of the put option (P&L)
     Cr.  Purchased put option (B/S)
(To record the change in the time value of the put option)

2.  Dr.  Purchased put option (B/S)
     Cr.  Unrealized gain on put option (P&L)
(To record the change in the intrinsic value portion of the purchased put option)

3.  Dr. Unrealized loss on investment in Company B (P&L)
     Cr.  Investment in Company B (B/S)
(To record the change in fair value of the investment in Company B; note that the entire loss on this investment was recognized in earnings because the loss is equal to the change in the put option's intrinsic value)

The journal entries made at December 31, 20X1 would be as follows:

1.  Dr.  Change in fair value of the time value portion of the put option (P&L)
     Cr.  Purchased put option (B/S)
(To record the change in the time value portion of the put option)

2.  Dr.  Purchased put option (B/S)
     Cr.  Unrealized gain on put option (P&L)
(To record the change in the intrinsic value of the purchased put option.  This entry would be made prior to the settlement of the put option)

3.  Dr.  Unrealized loss on investment in Company B (P&L)
     Cr.  Investment in Company B (B/S)
(To record the change in fair value of the investment in Company B; note that the entire loss on this investment was recognized in earnings since the loss is equal to the change in the put option's intrinsic value)

4.  Dr.  Cash (B/S)
     Cr.  Investment in Company B (B/S)
     Cr.  Purchased put option (B/S)
(To record the settlement of the purchased put option through delivery of the shares of Company B's stock at a price of $50 per share to Bank C)

5.  Dr.  AOCI (B/S)
     Cr.  Realized gain on investment in Company B (P&L)
(To reclassify the unrealized gain on Company B's shares from AOCI to earnings on the sale of the shares to Bank C)

Observations:

Even though Company B's share price fell to $30 per share, Bank A was able to lock in a $50 share price as a result of entering into the put option.  Thus, it was able to realize the gain of $2,000,000 (less the $200,000 premium paid for the option).

Because the intrinsic value of the put option was highly effective at offsetting changes in the fair value of Company A's investment in Company B's stock, each change in the intrinsic value of the put option recognized in earnings was offset by an equal amount representing the change in the investment in Company B's stock attributable to changes in interest rates.  In addition, the premium paid for the put option was recognized in earnings as the fair value of the time value portion of the put option changed over time.




$   200,000





       20,000



10,000,000






       30,000



  5,000,000



10,000,000
  5,000,000







     100,000



  5,000,000



  5,000,000







       50,000



10,000,000




10,000,000





50,000,000





  2,000,000
 




















$      200,000





        20,000



  10,000,000






         30,000



   5,000,000




 15,000,000







      100,000



  5,000,000



  5,000,000







      50,000



10,000,000




10,000,000





30,000,000
20,000,000




  2,000,000