Accounting for Investments, Volume 2: Fixed Income Securities and Interest Rate Derivatives—A Practitioner's Guide

COLLAR OR REVERSE COLLAR AS A HEDGING INSTRUMENT

A written option cannot be designated as a hedging instrument because the potential loss on an option that an entity writes could be significantly greater than the potential gain in value of a related hedged item. In this background can an interest rate collar or a reverse collar be designated as a hedging instrument? A collar as mentioned above contains both a purchased option (cap) and a written option (floor). A reverse collar also contains both a purchased option (floor) and a written option (cap). So, depending upon the movement of the interest rate over the life of the contract, the entity may either have to receive interest or pay interest. Or in other words, the net present value of the instrument may oscillate between a positive and negative number theoretically. Hence the question whether a collar can be designated as a hedging instrument.

This question has been considered by both US GAAP and IFRS, the answer being the following.

An interest rate collar or other derivative instrument that includes a written option cannot be designated as a hedging instrument if it is a net written option, because the standard precludes the use of a written option as a hedging instrument unless it is designated as an offset to a purchased option. However, an interest rate collar or other derivative instrument that includes a written option may be designated as a hedging instrument if the combination is a net purchased option or zero cost ...