FX differences with put option fair value accounting

In an earlier posting, “How do you calculate exchange gains and losses when using Fair Value Accounting?”  I considered how to apply the statutory rules for computing exchange gains and losses when a company is using fair value accounting.  A recent conversation with my partner Iain Hill, who leads our Finance & Treasury Network brought out some subtle points not addressed in the previous posting.

Structure under discussion

Iain was considering the situation illustrated below:

In this case, UK Co owns a subsidiary in the USA with net assets of, say $100.  In order to hedge the translation risk (see posting “Should companies hedge against translation risk?”) it purchases an American out of the money put option over $100 with a life of 18 months.  For example, if the spot exchange rate is £1=$2, the option exercise price may be at a rate of £1=$2.10.  Several points should be noted:

(a) The company remains exposed to translation risk if the dollar weakens against sterling, until the dollar falls to the £1=$2.10 rate.

(b) Choosing an out of the money option reduces its cost, (the option premium) compared with an option whose strike price is equal to the spot exchange rate.  For illustrative purposes, assume that the company pays £5 to purchase the option.

(c) As an American option, it can be exercised at any time in its life, as opposed to a European option which can only be exercised on the expiry date.

(d) If the dollar strengthens, the company will benefit from the increase in the sterling value of the $100 net assets of the US Subsidiary.  That opportunity is the commercial compensation for suffering the cost of the option premium.