B.1.2 Example II - Currency Options

On 1st June 2002, your bank buys a call option on 1000USD (in terms of INR) with a strike price of INR 50, and December 31st 2002 as the maturity date. The parameters of the deal are as follows:

Table B-25 Example II

Contract Type	Hedge
Contract Amount	1000
Contract Currency	USD
Counter Currency	INR
Option premium	2500 INR
Booking Date	01
Jun	2002
Value Date	01
Jun	2002
Premium Pay Date	01
Jun	2002
Strike price	50 INR/USD
Current Spot Rate	52 INR/USD
Option Style	Plain Vanilla
Expiration Style	American
Earliest Exercise Date	15
Oct	2002
Barrier Type	Double Knock Out
Barrier	53 INR/USD
Lower Barrier	48 INR/USD
Rebate	100 AUD
Payment At	Maturity
Barrier Window Start Date	01
Sep	2002
Barrier Window End Date	01
Nov	2002
Revaluation Frequency	Half Yearly
Revaluation Start Month	August
Revaluation Start Day	1

It is assumed the local currency in this case is neither USD nor INR or AUD

Intrinsic Value at Inception – Intrinsic value at inception is the pay off that can occur to the buyer if he were to exercise the option today.

Intrinsic Value = Contract Amount * (Spot rate – Strike Rate) in Counter CCY

In this case, the payoff is = 1000 * (52 –50) = 2000 INR

Time Value of the deal = Option premium paid – Intrinsic Value It is assumed the local currency in this case is neither USD nor INR or AUD Intrinsic Value at Inception – Intrinsic value at inception is the pay off that can occur to the buyer if he were to exercise the option today. Intrinsic Value = Contract Amount * (Spot rate – Strike Rate) in Counter CCY In this case the payoff is = 1000 * (52 –50) = 2000 INR Time Value of the deal = Option premium paid – Intrinsic Value = 2500 – 2000 = 500 INR

If the spot rate on the booking day was say 49 INR/USD (Lower than the strike rate), then the intrinsic value of the deal is 0 and the time value is the option premium paid.

BOOK

Table B-26 Accounting Entries

Dr/Cr	Accounting Role	Amount Tag	FCY Amount	FCY/CCY	Date
Dr	PUR_IV_DEF	PUR_INCEP_IV	2000	INR	01-Jun-02
Cr	OPT_PREM_PAY	PUR_INCEP_IV	2000	INR	01-Jun-02
Dr	PUR_TV_DEF	PUR_INCEP_TV	500	INR	01-Jun-02
Cr	OPT_PREM_PAY	PUR_INCEP_TV	500	INR	01-Jun-02

PRPT

Since option premium is paid on the booking date itself, this event triggers along with the BOOK event.

Table B-27 Accounting Entries

Dr/Cr	Accounting Role	Amount Tag	FCY Amount	FCY/CCY	Date
Dr	OPT_PREM_PAY	PUR_OPTION_PREM	2500	INR	01-Jun-02
Cr	CUSTOMER	PUR_OPTION_PREM	1000	INR	01-Jun-02

REVL

Amortization of Time Value occurs on 01-Aug-2002 as per the revaluation frequency.

Amt to Amort Till date = 500 * 60 / (7 * 30) = 142.86 INR

Table B-28 Accounting Entries

Dr/Cr	Accounting Role	Amount Tag	FCY Amount	FCY/CCY	Date
Dr	EXP_ON_HEDGE	NET_AMORT_TV	142.86	INR	01-Jun-02
Cr	PUR_TV_DEF	NET_AMORT_TV	142.86	INR	01-Jun-02

Option Getting Knocked Out

An option is get knocked out if the spot rate touches or crosses a predefined barrier between the barrier window start date and end date.

Event KNOT (Knock Out)

Now suppose, on 10-Sep-2002, the spot rate touches or crosses 53 INR/USD. The option is Knocked Out and a pre-specified rebate of 100 AUD is paid at maturity. On Knock Out deferred intrinsic value and the remaining time value is recognized as Expense.

Table B-29 Accounting Entries

Dr/Cr	Accounting Role	Amount Tag	FCY Amount	FCY/CCY	Date
Dr	PUR_REBATE_REC	PUR_REBATE_AMT	300	AUD	10-Sep-02
Cr	PUR_OPT_INCOME	PUR_REBATE_AMT	300	AUD	10-Sep-02
Dr	PUR_HED_EXPENSE	PUR_INCEP_IV	2000	INR	10-Sep-02
Cr	PUR_IV_DEF	PUR_INCEP_IV	2000	INR	10-Sep-02

Remaining amortization of time value is done at the time of the option getting knocked out and the total expense is moved to the main option expense GL.

REVL on Knock Out

TV amortized Till date = 142.86 INR

Total TV to be amortized = 500 INR

Current TV to be amortized = 500 – 142.86 = 357.14 INR

Table B-30 Accounting Entries

Dr/Cr	Accounting Role	Amount Tag	FCY Amount	FCY/CCY	Date
Dr	EXP_ON_HEDGE	NET_AMORT_TV	357.14	INR	10-Sep-02
Cr	PUR_TV_DEF	NET_AMORT_TV	357.14	INR	10-Sep-02

Moving Inception TV to final Expense GL from Revaluation Expense GL

Table B-31 Accounting Entries

Dr/Cr	Accounting Role	Amount Tag	FCY Amount	FCY/CCY	Date
Dr	PUR_HED_EXPENSE	PUR_INCEP_TV	500	INR	10-Sep-02
Cr	EXP_ON_HEDGE	PUR_INCEP_TV	500	INR	10-Sep-02

Event KNST (Knock Out Settlement)

In the above case the rebate is actually received on the maturity date of the contract. Accounting entries posted on the maturity i.e. 31-Dec-2002 are:

Table B-32 Accounting Entries

Dr/Cr	Accounting Role	Amount Tag	FCY Amount	FCY/CCY	Date
Dr	CUSTOMER	PUR_REBATE_AMT	300	AUD	31-Dec-02
Cr	PUR_REBATE_REC	PUR_REBATE_AMT	300	AUD	31-Dec-02

Option not getting Knocked In

Let us assume that the barrier type is Double Knock In instead of Double Knock Out. If the option gets knocked in during the barrier window, it can be exercised any time according to the Expiration style. If it doesn’t get knocked in, a rebate is payable at expiry. Let us suppose that the option doesn’t get knocked in. The accounting entries and the events triggered at expiry in this case are given below.

REVL at expiry

TV amortized Till date = 142.86 INR

Total TV to amortize = 500 INR

Current TV to amortize = 500 – 142.86 = 357.14 INR

Table B-33 Accounting Entries

Dr/Cr	Accounting Role	Amount Tag	FCY Amount	FCY/CCY	Date
Dr	EXP_ON_HEDGE	NET_AMORT_TV	357.14	INR	31-Dec-02
Cr	PUR_TV_DEF	NET_AMORT_TV	357.14	INR	31-Dec-02

KIST (Knock In settlement) at expiry

As mentioned above, a rebate amount is payable to the buyer of the option on expiry if the option does not get knocked in during the barrier window.

Table B-34 Accounting Entries

Dr/Cr	Accounting Role	Amount Tag	FCY Amount	FCY/CCY	Date
Dr	CUSTOMER	PUR_REBATE_AMT	300	AUD	31-Dec-02
Cr	PUR_OPT_INCOME	PUR_REBATE_AMT	300	AUD	31-Dec-02

EXPR (Expiry)

On Expiry, the deferred intrinsic value is recognized as expense

Table B-35 Accounting Entries

Dr/Cr	Accounting Role	Amount Tag	FCY Amount	FCY/CCY	Date
Dr	PUR_HED_EXPENSE	PUR_INCEP_IV	2000	INR	31-Dec-02
Cr	PUR_IV_DEF	PUR_INCEP_IV	2000	INR	31-Dec-02

Moving Inception TV to final Expense GL from Revaluation Expense GL

Table B-36 Accounting Entries

Dr/Cr	Accounting Role	Amount Tag	FCY Amount	FCY/CCY	Date
Dr	PUR_HED_EXPENSE	PUR_INCEP_TV	500	INR	31-Dec-02
Cr	EXP_ON_HEDGE	PUR_INCEP_TV	500	INR	31-Dec-02

Contract Termination (TERM)

Now let us assume that the currency option contract was terminated on 01-Sep-2002

Termination Value (User I/P) = 2700 INR

Termination Gain = 2700 – 2000 (Inception IV) = 700 INR

Accounting entries passed at termination –

Table B-37 Accounting Entries

Dr/Cr	Accounting Role	Amount Tag	FCY Amount	FCY/CCY	Date
Dr	CUSTOMER	PUR_INCEP_IV	2000	INR	01-Jul-02
Cr	PUR_IV_DEF	PUR_INCEP_IV	2000	INR	01-Jul-02
Dr	CUSTOMER	HED_TERM_GAIN	700	INR	01-Jul-02
CR	PUR_GAIN_DEF	HED_TERM_GAIN	700	INR	01-Jul-02

Event REVL at termination

Remaining time value of the option is recognized as expense on termination.

TV amortized Till date = 142.86 INR (As on 01-Aug-2002)

Total TV to be amortized = 500 INR

Current TV to be amortized = 500 – 142.86 = 357.14 INR

Table B-38 Accounting Entries

Dr/Cr	Accounting Role	Amount Tag	FCY Amount	FCY/CCY	Date
Dr	EXP_ON_HEDGE	NET_AMORT_TV	357.14	INR	01-Sep-02
Cr	PUR_TV_DEF	NET_AMORT_TV	357.14	INR	01-Sep-02

Moving Inception TV to final Expense GL from Revaluation Expense GL after REVL on TERM.

Table B-39 Accounting Entries

Dr/Cr	Accounting Role	Amount Tag	FCY Amount	FCY/CCY	Date
Dr	PUR_HED_EXPENSE	PUR_INCEP_TV	500	INR	01-Sep-02
Cr	EXP_ON_HEDGE	PUR_INCEP_TV	500	INR	01-Sep-02

AMDG after termination

Deferred termination gain in case of hedge deals is amortized over a period from Contract termination date (01-Sep-2002 in this case) to the contract maturity date. Suppose according to the frequency of amortization, deferred termination gain is amortized on the 01-Nov-2002.

Amount to be amortized Till date = 700 * (2 * 30) / (6 * 30) = 233.33 INR

Table B-40 Accounting Entries

Dr/Cr	Accounting Role	Amount Tag	FCY Amount	FCY/CCY	Date
Dr	PUR_GAIN_DEF	NET_GAIN_DEF	233.33	INR	01-Nov-02
CR	PUR_OPT_INCOME	NET_GAIN_DEF	233.33	INR	01-Nov-02

If there is no other frequency of amortization between the contract termination date and contract maturity date where the deferred termination gain can be amortized, the remaining part is amortized on the contract maturity date. Since the contract has already been terminated, only the event AMDG is triggered. The accounting entries are

Amt to amortize till date = 700 INR

Amt already amortized = 233.33 INR

Current amount to amortize = 700 – 233.33 = 467.67 INR

Table B-41 Accounting Entries

Dr/Cr	Accounting Role	Amount Tag	FCY Amount	FCY/CCY	Date
Dr	PUR_GAIN_DEF	NET_GAIN_DEF	467.67	INR	31-Dec-02
CR	PUR_OPT_INCOME	NET_GAIN_DEF	467.67	INR	31-Dec-02

Contract Exercise (EXER)

Contract Exercise happens depending on the Expiration style. In this case, since it’s a Plain Vanilla option with American Expiration style, it can be exercised anytime between the earliest exercise date (15-Oct-2002) and contract maturity (31-Dec-2002) if it doesn’t get knocked out during the barrier window.

Suppose the spot rate on 15-Dec-2002 is 55INR/USD. Since the strike is 50 INR/USD, the option is in the money on this date and the buyer can exercise the option.

Settlement Amount = 1000 (Contract Amount) * (55 – 50) = 500 INR

Table B-42 Accounting Entries

Dr/Cr	Accounting Role	Amount Tag	FCY Amount	FCY/CCY	Date
Dr	PUR_OPT_SET_REC	PUR_INCEP_IV	2000	INR	15-Dec-02
CR	PUR_IV_DEF	PUR_INCEP_IV	2000	INR	15-Dec-02
Dr	PUR_HED_EXPENSE	HED_EXER_LOSS	1500	INR	15-Dec-02
Cr	PUR_OPT_SET_REC	HED_EXER_LOSS	1500	INR	15-Dec-02

It is important to note here that even though, the option is in the money, the amount tag populated here is HED_EXER_LOSS. This is so because even though the buyer of the option is getting a pay off equal to 500 INR, he is in an over all loss of 1500 INR (Inception IV – pay off).

AMRT on EXER

Remaining time value of the option is recognized as expense at the time of Exercise.

TV amortized Till date = 142.86 INR (As on 01-Aug-2002)

Total TV to be amortized = 500 INR

Current TV to be amortized = 500 – 142.86 = 357.14 INR

Table B-43 Accounting Entries

Dr/Cr	Accounting Role	Amount Tag	FCY Amount	FCY/CCY	Date
Dr	EXP_ON_HEDGE	NET_AMORT_TV	357.14	INR	15-Dec-02
Cr	PUR_TV_DEF	NET_AMORT_TV	357.14	INR	15-Dec-02

Moving Inception TV to final Expense GL from Revaluation Expense GL on EXER after AMRT.

Table B-44 Accounting Entries

Dr/Cr	Accounting Role	Amount Tag	FCY Amount	FCY/CCY	Date
Dr	PUR_HED_EXPENSE	PUR_INCEP_TV	500	INR	15-Dec-02
Cr	EXP_ON_HEDGE	PUR_INCEP_TV	500	INR	15-Dec-02

EXST (Exercise Settlement) after EXER

The following accounting entries pass on settlement after exercise of the currency option above. In this case the settlement event is triggered along with the exercise event.

Table B-45 Accounting Entries

Dr/Cr	Accounting Role	Amount Tag	FCY Amount	FCY/CCY	Date
Dr	CUSTOMER	PUR_SETL_AMT	500	USD	15-Dec-02
Cr	PUR_OPT_SET_REC	PUR_SETL_AMT	500	USD	15-Dec-02