Do Leveraged Options Qualify for Hedge Accounting Treatment?

Risk management professionals are constantly coming out with new exotic options. These options have strange names, such as ‘Seagull’ or ‘Knock-in and Knock-outs’. 

Despite the exciting names, leveraged options often come with disadvantaged accounting treatment.

Do you know if your accounting policy allows for these types of products to be used?

How about the accounting treatment you are required to follow?

These questions are essential to answer before you enter into any transaction with a leveraged option, making it essential to understand the basics, why hedge accounting is disallowed, and ways to overcome the unfavourable treatment. 

What is a Leveraged Option?

An exotic option is a category of contracts that don’t have the traditional payment structures, strike prices, and expiration dates. Many portfolios want to include exotic options because of the customisation capabilities in risk tolerance. Although exotic options provide investors with added flexibility, there is no guarantee of profits. 

Can a Leveraged Option Qualify for Hedge Accounting?

Since leveraged options are regarded as net-written options, they do not qualify for hedge accounting treatment. This results in fair value movements reflected in the Profit & Loss statement which can distort your financial performance.

To qualify for hedge accounting, the relationship between the hedging instrument and the item being hedged must be highly effective. A net-written option can expose you to more risk not present in the underlying exposure; therefore, they do not meet the necessary criteria. 

Reporting the leveraged option directly on the Profit & Loss statement makes it important to select hedges carefully. Investors, lenders, and other third parties are concerned with the figures reported on that statement. 

What are Ways to Overcome This Disadvantage?

Before entering any exotic trades or agreements, be sure you understand the accounting treatment to avoid undesirable outcomes. In addition, delays in executing trades can lead to missed opportunities when the market moves away from a favourable position. This is why it’s essential to fully understand the accounting policies you must follow beforehand.

Before you execute any exotic trades, you should go through the following steps:

• Check if your accounting policy is current and allows for the use of these products.

• Understand the rules and regulations surrounding the accounting treatment before you enter into a deal.

Entering into transactions with unfavourable accounting treatment can negatively impact your personal brand and the image of your company. Study the regulations surrounding exotic options to preserve your brand image, ensure favourable accounting treatment, and have clarity throughout the entire process. 

Exotic options come with special accounting treatment outside of hedge accounting. This can create an unfavourable situation based on the goals of your business.

Given the complexity and specialised nature of hedge accounting, it is unlikely that the average accountant will have the necessary expertise to determine whether your exotic option qualifies for hedge accounting. Therefore, it is essential to work with an independent expert who has the knowledge and experience to guide you through the intricacies of hedge accounting.

For more information on Hedge Accounting or advice on a specific hedge accounting challenge, contact our team at info@hedgeeffective.com