Hedge Accounting Treatment for FX or Commodity Options – A Technical OverviewA hedge with FX or commodity options as the hedging instrument could be treated as either a fair value or cash flow hedge, depending on the risk being hedged. A critical requirement before one can apply hedge accounting is the analysis that supports the assessment of hedge effectiveness. When valuing an option, it is convenient to break it down into intrinsic value and time value. Both IFRS and US GAAP permit designating a purchased option or a combination of purchased options, as hedging instruments.

The intrinsic value of an FX or commodity option can be calculated using either the spot rate or the forward rate, and the time value is just any value of the option other than its intrinsic value.
IFRS requires the intrinsic value to be separated from the time value of an option, and only the intrinsic value is included in the hedge relationship.
This requirement means the effectiveness is assessed based on changes in the option's intrinsic value only (either spot or forward intrinsic value can be used).
In practice there are more cash flow hedges with options and that is what the remainder of this technical overview will focus on for further discussions.

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