68

Accounting for Derivatives

between the two currencies of the FX forward, and consequently, that the changes in fair
value of the forward due to changes in the forward points should be recorded in the interest
income and expense line of P&L. Alternatively, we have seen some entities recognising
these changes within EBITDA as operating income and expense. In our view this quite an
aggressive interpretation of accounting guidelines.

CASE 3.2
Hedging a Highly Expected Foreign Sale with a Tunnel
The risk being hedged in this case is the same as the previous one: the hedge of a highly
expected sale denominated in a foreign currency. The hedging instrument in this case is a
tunnel. This case highlights the unfavourable treatment of options under IAS 39 due to the
exclusion of the time value from the hedging relationship.
The starting point of this case is identical to the previous case. Let us assume that on 1
October 20X4 ABC Corporation, a company whose functional currency was the EUR, was
expecting to sell finished goods to a US client. The sale was expected to occur on 31 March
20X5, and the sale receivable was expected to be settled on 30 June 20X5. Sale proceeds
were expected to be USD 100 million to be received in USD.
ABC had the view that the USD could appreciate against the EUR and wanted to benefit
were its view right. At the same time, ABC wanted to have a protection, were its view
wrong. As a consequence, on 1 October 20X4 ABC entered into a FX tunnel with the
following terms:
USD Put/EUR Call Terms
Trade date
Option buyer
Option seller
USD Notional
Strike
EUR Notional
Expiry date
Settlement
Premium
Premium payment date

1 October 20X4
ABC
XYZ Bank
USD 100 million
1.2900
EUR 77,519,000
30 June 20X5
Physical delivery
EUR 1,400,000
1 October 20X4

USD Call/EUR Put Terms

Trade date
Option buyer
Option seller
USD Notional
Strike
EUR Notional
Expiry date
Settlement
Premium
Premium payment date

1 October 20X4
XYZ Bank
ABC
USD 100 million
1.2120
EUR 82,508,000
30 June 20X5
Physical delivery
EUR 1,400,000
1 October 20X4

In the FX options market, the term call (or put) is accompanied by the currency to which it
is a call (or put), as discussed in Chapter 2. Additionally, a call on one of the two currencies
is a put on the other currency. For example, when referring to a USD/EUR option, a call on
the USD automatically implies a put on the EUR. In our case, ABC bought a USD put (or
EUR call) with strike 1.2900. The USD put gave ABC the right, but not the obligation to
sell USD 100 million at a rate of 1.2900 on expiry date. This option protected ABCs sale
from a depreciating USD above 1.2900. Consequently, ABC would only exercise the USD
put if the USD/EUR exchange rate exceeded 1.2900 on expiry date, receiving then EUR
77,519,000 in exchange for the USD 100 million.