AUD 3 Internal Control 16 - 8 Investing and Financing Cycle - Derivatives and Hedge Accounting (Examples) Flashcards
Interest Rate Swap
Example:
(LO 6)
On January 2, 2017, MacCloud Co. issued a 4 year, $100,000 note at 6% fixed interest, interest payable semiannually.
MacCloud now wants to change the note to a variable-rate note.
As a result, on January 2, 2017, MacCloud Co. enters into an interest rate swap where it agrees to receive 6% fixed and pay LIBOR (variable Rate) of 5.7% for the first 6 months on $100,000. At each 6-month period, the variable rate will be reset. The variable rate is reset to 6.7% on June 30, 2017.
Instructions
(a) Compute the net interest expense to be reported for this note and related swap transaction as of June 30, 2017.
(b) Compute the net interest expense to be reported for this note and related swap transaction as of December 31, 2017.
Interest Rate Swap
Example:
(LO 6)
On January 2, 2017, MacCloud Co. issued a 4 year, $100,000 note at 6% fixed interest, interest payable semiannually.
MacCloud now wants to change the note to a variable-rate note.
As a result, on January 2, 2017, MacCloud Co. enters into an interest rate swap where it agrees to receive 6% fixed and pay LIBOR (variable Rate) of 5.7% for the first 6 months on $100,000. At each 6-month period, the variable rate will be reset. The variable rate is reset to 6.7% on June 30, 2017.
Instructions
(a) Compute the net interest expense to be reported for this note and related swap transaction as of June 30, 2017.
(b) Compute the net interest expense to be reported for this note and related swap transaction as of December 31, 2017.
Interest Rate Swap
Example:
(LO 6)
On January 2, 2017, MacCloud Co. issued a 4 year, $100,000 note at 6% fixed interest, interest payable semiannually.
MacCloud now wants to change the note to a variable-rate note.
As a result, on January 2, 2017, MacCloud Co. enters into an interest rate swap where it agrees to receive 6% fixed and pay LIBOR (variable Rate) of 5.7% for the first 6 months on $100,000. At each 6-month period, the variable rate will be reset. The variable rate is reset to 6.7% on June 30, 2017.
Instructions
(a) Compute the net interest expense to be reported for this note and related swap transaction as of June 30, 2017.
(b) Compute the net interest expense to be reported for this note and related swap transaction as of December 31, 2017.
Explain
MacCloud Co. issued a note (borrowing money) at fixed rate 6%
MacCloud Co. want to get variable rate, thinking it is cheaper interest expense, at 5.7%
Counter-party also has the note at variable rate at 5.7% but want a fixed rate at 6%
So MacCloud Co. and Counter-party swap their interest payment on their $100,000 note. They both will be paying each other interest on the debt.
Interest Rate Swap
Example:
(LO 6)
On January 2, 2017, MacCloud Co. issued a 4 year, $100,000 note at 6% fixed interest, interest payable semiannually.
MacCloud now wants to change the note to a variable-rate note.
As a result, on January 2, 2017, MacCloud Co. enters into an interest rate swap where it agrees to receive 6% fixed and pay LIBOR (variable Rate) of 5.7% for the first 6 months on $100,000. At each 6-month period, the variable rate will be reset. The variable rate is reset to 6.7% on June 30, 2017.
Instructions
(a) Compute the net interest expense to be reported for this note and related swap transaction as of June 30, 2017.
(b) Compute the net interest expense to be reported for this note and related swap transaction as of December 31, 2017.
Explain
MacCloud Co. issued a note (borrowing money) at fixed rate 6%
MacCloud Co. want to get variable rate, thinking it is cheaper interest expense, at 5.7%
Counter-party also has the note at variable rate at 5.7% but want a fixed rate at 6%
So MacCloud Co. and Counter-party swap their interest payment on their $100,000 note. They both will be paying each other interest on the debt.
Interest Rate Swap
Example:
(LO 6)
On January 2, 2017, MacCloud Co. issued a 4 year, $100,000 note at 6% fixed interest, interest payable semiannually.
MacCloud now wants to change the note to a variable-rate note.
As a result, on January 2, 2017, MacCloud Co. enters into an interest rate swap where it agrees to receive 6% fixed and pay LIBOR (variable Rate) of 5.7% for the first 6 months on $100,000. At each 6-month period, the variable rate will be reset. The variable rate is reset to 6.7% on June 30, 2017.
Instructions
(a) Compute the net interest expense to be reported for this note and related swap transaction as of June 30, 2017.
(b) Compute the net interest expense to be reported for this note and related swap transaction as of December 31, 2017.
Calculate Interest Expense for 6 months:
Fixed Rate at 6.0%
$100,000 x 6.0% x (½) = $3,000
Variable Rate at 5.7%
$100,000 x 5.7% x (½) = $2,850
Variable Rate at 6.7%
$100,000 x 6.7% x (½) = $3,350
Interest Rate Swap
Example:
(LO 6)
On January 2, 2017, MacCloud Co. issued a 4 year, $100,000 note at 6% fixed interest, interest payable semiannually.
MacCloud now wants to change the note to a variable-rate note.
As a result, on January 2, 2017, MacCloud Co. enters into an interest rate swap where it agrees to receive 6% fixed and pay LIBOR (variable Rate) of 5.7% for the first 6 months on $100,000. At each 6-month period, the variable rate will be reset. The variable rate is reset to 6.7% on June 30, 2017.
Instructions
(a) Compute the net interest expense to be reported for this note and related swap transaction as of June 30, 2017.
(b) Compute the net interest expense to be reported for this note and related swap transaction as of December 31, 2017.
Calculate Interest Expense for 6 months:
Fixed Rate at 6.0%
$100,000 x 6.0% x (½) = $3,000
Variable Rate at 5.7%
$100,000 x 5.7% x (½) = $2,850
Variable Rate at 6.7%
$100,000 x 6.7% x (½) = $3,350
Interest Rate Swap
Example:
(LO 6)
On January 2, 2017, MacCloud Co. issued a 4 year, $100,000 note at 6% fixed interest, interest payable semiannually.
MacCloud now wants to change the note to a variable-rate note.
As a result, on January 2, 2017, MacCloud Co. enters into an interest rate swap where it agrees to receive 6% fixed and pay LIBOR (variable Rate) of 5.7% for the first 6 months on $100,000. At each 6-month period, the variable rate will be reset. The variable rate is reset to 6.7% on June 30, 2017.
Instructions
(a) Compute the net interest expense to be reported for this note and related swap transaction as of June 30, 2017.
(b) Compute the net interest expense to be reported for this note and related swap transaction as of December 31, 2017.
(a) June 30, 2017 ——
MacCloud Co. will pay variable rate at 5.7%
$100,000 x 5.7% x (½) = $2,850
Counter Party will pay fixed rate at 6.0%
$100,000 x 6.0% x (½) = $3,000
(b) December 31, 2017
MacCloud Co. will pay variable rate at 6.7%
$100,000 x 6.7% x (½) = $3,350
Counter Party will pay fixed rate at 6.0%
$100,000 x 6.0% x (½) = $3,000
Interest Rate Swap
Example:
(LO 6)
On January 2, 2017, MacCloud Co. issued a 4 year, $100,000 note at 6% fixed interest, interest payable semiannually.
MacCloud now wants to change the note to a variable-rate note.
As a result, on January 2, 2017, MacCloud Co. enters into an interest rate swap where it agrees to receive 6% fixed and pay LIBOR (variable Rate) of 5.7% for the first 6 months on $100,000. At each 6-month period, the variable rate will be reset. The variable rate is reset to 6.7% on June 30, 2017.
Instructions
(a) Compute the net interest expense to be reported for this note and related swap transaction as of June 30, 2017.
(b) Compute the net interest expense to be reported for this note and related swap transaction as of December 31, 2017.
(a) June 30, 2017 ——
MacCloud Co. will pay variable rate at 5.7%
$100,000 x 5.7% x (½) = $2,850
Counter Party will pay fixed rate at 6.0%
$100,000 x 6.0% x (½) = $3,000
(b) December 31, 2017
MacCloud Co. will pay variable rate at 6.7%
$100,000 x 6.7% x (½) = $3,350
Counter Party will pay fixed rate at 6.0%
$100,000 x 6.0% x (½) = $3,000
Investing and Financing Cycle
An entity uses derivatives as hedges to protect itself against various risks that may be inherent in the assets or liabilities they hold, in anticipated transactions, or other aspects of their business.
The purpose of the hedge is to shift the risk to a counter-party.
For example:
1) Fair Value Hedge
2) Cash Flow Hedge
Cash Flow Hedge
• An entity with a variable rate receivable may be concerned about the uncertainty of future cash inflows due to fluctuations in the interest rate.
They might enter into an interest rate swap in which they will pay out interest at a variable rate, to offset the interest received, and receive interest from the counter-party at a fixed rate.
o As a result, regardless of changes in the market interest rate, the entity will receive a steady and predictable stream of interest cash inflows. o This would be considered a cash flow hedge.
Fair Value Hedge
• An entity with a fixed rate receivable may be concerned that fluctuations in interest rates will affect its fair value.
They might enter into an interest rate swap in which they will pay out interest at a fixed rate, to offset the interest received, and receive interest from the counter-party at a variable rate.
o As a result, they will always be paying the market rate of interest and changes in the fair value of the note will be offset by changes in the fair value of the derivative used as a hedge. o This would be considered a fair value hedge.
Investing and Financing Cycle
An entity uses derivatives as hedges to protect itself against various risks that may be inherent in the assets or liabilities they hold, in anticipated transactions, or other aspects of their business.
The purpose of the hedge is to shift the risk to a counter-party.
For example:
1) Fair Value Hedge
2) Cash Flow Hedge
Cash Flow Hedge
• An entity with a variable rate receivable may be concerned about the uncertainty of future cash inflows due to fluctuations in the interest rate.
They might enter into an interest rate swap in which they will pay out interest at a variable rate, to offset the interest received, and receive interest from the counter-party at a fixed rate.
o As a result, regardless of changes in the market interest rate, the entity will receive a steady and predictable stream of interest cash inflows. o This would be considered a cash flow hedge.
Fair Value Hedge
• An entity with a fixed rate receivable may be concerned that fluctuations in interest rates will affect its fair value.
They might enter into an interest rate swap in which they will pay out interest at a fixed rate, to offset the interest received, and receive interest from the counter-party at a variable rate.
o As a result, they will always be paying the market rate of interest and changes in the fair value of the note will be offset by changes in the fair value of the derivative used as a hedge. o This would be considered a fair value hedge.
Interest Rate Swap
June 30, 2017
Fixed rate 6%
Variable rate at 5.7%
Fair Value Hedge
change to Fixed rate --> Variable rate
Example: MacCloud Co. with $100k note
June 30, 2017
fixed rate 6% –> variable rate at 5.7%
Interest expense
$3,000 –> $2,850
Result: June 30, 2017
MacCloud Co. gain
$3,000 - $2,850 = $150
Cash Flow Hedge
change to Variable rate --> Fixed rate
Example: Counter-party with $100k note
June 30, 2017
variable rate at 5.7% –> fixed rate 6%
Interest expense
$2,850 –> $3,000
Result: June 30, 2017
Counter-party loss
$3,000 - $2,850 = $150
Interest Rate Swap
June 30, 2017
Fixed rate 6%
Variable rate at 5.7%
Fair Value Hedge
change to Fixed rate --> Variable rate
Example: MacCloud Co. with $100k note
June 30, 2017
fixed rate 6% –> variable rate at 5.7%
Interest expense
$3,000 –> $2,850
Result: June 30, 2017
MacCloud Co. save
$3,000 - $2,850 = $150
Cash Flow Hedge
change to Variable rate --> Fixed rate
Example: Counter-party with $100k note
June 30, 2017
variable rate at 5.7% –> fixed rate 6%
Interest expense
$2,850 –> $3,000
Result: June 30, 2017
Counter-party loss
$3,000 - $2,850 = $150
Interest Rate Swap
December 31, 2017
Fixed rate 6%
Variable rate at 6.7%
Fair Value Hedge
change to Fixed rate --> Variable rate
Example: MacCloud Co. with $100k note
December 31, 2017
fixed rate 6% –> variable rate at 6.7%
Interest expense
$3,000 –> $3,350
Result: December 31, 2017
MacCloud Co. loss
$3,350 - $3,000 = $350
Total loss in 2017
\+$150 - $350 = $200
Cash Flow Hedge
change to Variable rate --> Fixed rate
Example: Counter-party with $100k note
December 31, 2017
variable rate at 6.7% –> fixed rate 6%
Interest expense
$3,350 –> $3,000
Result: December 31, 2017
Counter-party gain
$3,350 - $3,000 = $350
Total gain 2017
-$150 + $350 = +$200
Interest Rate Swap
December 31, 2017
Fixed rate 6%
Variable rate at 6.7%
Fair Value Hedge
change to Fixed rate --> Variable rate
Example: MacCloud Co. with $100k note
December 31, 2017
fixed rate 6% –> variable rate at 6.7%
Interest expense
$3,000 –> $3,350
Result: December 31, 2017
MacCloud Co. loss
$3,350 - $3,000 = $350
Total loss in 2017
\+$150 - $350 = $200
Cash Flow Hedge
change to Variable rate --> Fixed rate
Example: Counter-party with $100k note
December 31, 2017
variable rate at 6.7% –> fixed rate 6%
Interest expense
$3,350 –> $3,000
Result: December 31, 2017
Counter-party gain
$3,350 - $3,000 = $350
Total gain 2017
-$150 + $350 = +$200
What is a fair value hedge?
Fair Value Hedge =
A he___ of the exp_____ to changes in the fair value of a recognized asset or liability,
What is a fair value hedge?
Fair Value Hedge =
A hedge of the exposure to changes in the fair value of a recognized asset or liability,
What is a fair value hedge?
Fair Value Hedge =
A hedge of the exposure to ch___es in the f___ value of a recognized asset or liability,
What is a fair value hedge?
Fair Value Hedge =
A hedge of the exposure to changes in the fair value of a recognized asset or liability,
What is a fair value hedge?
Fair Value Hedge =
A hedge of the exposure to changes in the fair value of a re______ed as___ or liability,
What is a fair value hedge?
Fair Value Hedge =
A hedge of the exposure to changes in the fair value of a recognized asset or liability,
What is a fair value hedge?
Fair Value Hedge =
A hedge of the exposure to changes in the fair value of a recognized asset or liability,
or of an unre_______ed firm comm_______, that are attributable to a particular risk.
What is a fair value hedge?
Fair Value Hedge =
A hedge of the exposure to changes in the fair value of a recognized asset or liability,
or of an unrecognized firm commitment, that are attributable to a particular risk.
What is a fair value hedge?
Fair Value Hedge =
A hedge of the exposure to changes in the fair value of a recognized asset or liability,
or of an unrecognized firm commitment, that are attr________ to a particular ri__.
What is a fair value hedge?
Fair Value Hedge =
A hedge of the exposure to changes in the fair value of a recognized asset or liability,
or of an unrecognized firm commitment, that are attributable to a particular risk.
What is a fair value hedge?
Fair Value Hedge =
A hedge of the exposure to changes in the fair value of a recognized asset or liability,
or of an unrecognized firm commitment, that are attributable to a particular risk.
Fair value hedges protect existing assets, liabilities and firm commitments against changes in fair value.
The exposure to changes in fair value can result from a variety of causes including holding a commodity, being committed to purchase or sell something on predetermined terms or issuing or holding a financial instrument that has a fixed interest rate and maturity.
What is a fair value hedge?
Fair Value Hedge =
A hedge of the exposure to changes in the fair value of a recognized asset or liability,
or of an unrecognized firm commitment, that are attributable to a particular risk.
Fair value hedges protect existing assets, liabilities and firm commitments against changes in fair value.
The exposure to changes in fair value can result from a variety of causes including holding a commodity, being committed to purchase or sell something on predetermined terms or issuing or holding a financial instrument that has a fixed interest rate and maturity.
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a scenario in which the entity would be required to pay a premium if it decided to extinguish its debt prior to maturity if interest rates decline.
Similarly, if rates increase, the entity would have a gain upon early extinguishment of its debt. The presence of an interest rate swap would offset such a gain or loss.
Note that this discussion focuses on the fair value of the debt.
This focus taken by ASC 815 is often different from that of most entities, which in this situation are usually focused on the interest cash flows each period rather than the value of the debt in the event of a hypothetical extinguishment.
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a scenario in which the entity would be required to pay a premium if it decided to extinguish its debt prior to maturity if interest rates decline.
Similarly, if rates increase, the entity would have a gain upon early extinguishment of its debt. The presence of an interest rate swap would offset such a gain or loss.
Note that this discussion focuses on the fair value of the debt.
This focus taken by ASC 815 is often different from that of most entities, which in this situation are usually focused on the interest cash flows each period rather than the value of the debt in the event of a hypothetical extinguishment.
Interest Rate Swap
Example
An entity with fixed-rate d__t ent__s into an interest rate swap
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an inte____ rate sw__ to receive a fixed rate
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fi__d rate of int____t
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and p__ a variable rate
Fair Value Hedge
change to
Fixed rate –> Variable rate
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
Fair Value Hedge
change to
Fixed rate –> Variable rate
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a var______ rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a scenario
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a scenario
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to pro____ against a scenario
in which the entity would be required to pay a premium
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a scenario
in which the entity would be required to pay a premium
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a sce_____
in which the e___ty would be required to pay a premium
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a scenario
in which the entity would be required to pay a premium
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a scenario
in which the entity would be re____ed to p__ a premium
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a scenario
in which the entity would be required to pay a premium
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a scenario
in which the entity would be required to pay a pre____ if it decided to extinguish its debt prior to maturity
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a scenario
in which the entity would be required to pay a premium if it decided to extinguish its debt prior to maturity
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a scenario
in which the entity would be required to pay a premium if it decided to extin_____ its debt prior to maturity
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a scenario
in which the entity would be required to pay a premium if it decided to extinguish its debt prior to maturity
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a scenario
in which the entity would be required to pay a premium if it decided to extinguish its debt pr___ to maturity
if interest rates decline.
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a scenario
in which the entity would be required to pay a premium if it decided to extinguish its debt prior to maturity
if interest rates decline.
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a scenario
in which the entity would be required to pay a premium if it decided to extinguish its debt prior to m_____ty
if interest rates decline.
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a scenario
in which the entity would be required to pay a premium if it decided to extinguish its debt prior to maturity
if interest rates decline.
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a scenario
in which the entity would be required to pay a premium if it decided to extinguish its debt prior to maturity
if inte____ rates de_____.
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a scenario
in which the entity would be required to pay a premium if it decided to extinguish its debt prior to maturity
if interest rates decline.
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a scenario
in which the entity would be required to pay a premium if it decided to extinguish its debt prior to maturity
if interest rates decline.
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
to protect against a scenario
in which the entity would be required to pay a premium if it decided to extinguish its debt prior to maturity
if interest rates decline.
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
January 1, 2019
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
6% –> 6.5%
to protect against a scenario
in which the entity would be required to pay a premium if it decided to extinguish its debt prior to maturity
if interest rates decline.
(explain)
Future (1 year later)
January 1, 2020
Interest Rate
in the future Fixed rate debt --> Variable rate debt
6% --> 5.0%
If the interest will decrease to 5.0% in the future.
the firm will pay higher interest on the fixed rate debt at 6.0%.
Therefore, the entity is required to pay a premium if it decides to extinguish its debt prior to maturity
when interest rates decline.
(The debtor will loose the interest gain on fixed rate (6.0% - 5.0% = 1%)
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest and pay a variable rate
January 1, 2019
(Fair Value Hedge)
change to
Fixed rate debt –> Variable rate debt
6% –> 6.5%
to protect against a scenario
in which the entity would be required to pay a premium if it decided to extinguish its debt prior to maturity
if interest rates decline.
(explain)
Future (1 year later)
January 1, 2020
Interest Rate
in the future Fixed rate debt --> Variable rate debt
6% --> 5.0%
If the interest will decrease to 5.0% in the future.
the firm will pay higher interest on the fixed rate debt at 6.0%.
Therefore, the entity is required to pay a premium if it decides to extinguish its debt prior to maturity
when interest rates decline.
(The debtor will loose the interest gain on fixed rate (6.0% - 5.0% = 1%)
Another example,
a refinery, concerned that crude prices may fall
while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity as if it had purchased the crude at the lower hedged market price.
However, if crude oil prices increase,
the loss on the futures contract will result in the refinery paying an effective cost over and above the fixed purchase contract price.
Another example,
a refinery, concerned that crude prices may fall
while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity as if it had purchased the crude at the lower hedged market price.
However, if crude oil prices increase,
the loss on the futures contract will result in the refinery paying an effective cost over and above the fixed purchase contract price.
Another example,
a refinery, concerned that crude pr__es may fall
Another example,
a refinery, concerned that crude prices may fall
Another example,
a refinery, concerned that crude prices may f__l
Another example,
a refinery, concerned that crude prices may fall
Another example,
a refinery, concerned that crude prices may fall
while it is firmly com___ted under a purchase contract
Another example,
a refinery, concerned that crude prices may fall
while it is firmly committed under a purchase contract
Another example,
a refinery, concerned that crude prices may fall
while it is firmly committed under a purc____ contract
Another example,
a refinery, concerned that crude prices may fall
while it is firmly committed under a purchase contract
Another example,
a refinery, concerned that crude prices may fall
while it is firmly committed under a purchase contr___
to buy one million barrels of crude oil at a fixed price
Another example,
a refinery, concerned that crude prices may fall
while it is firmly committed under a purchase contract
to buy one million barrels of crude oil at a fixed price
Another example,
a refinery, concerned that crude prices may fall
while it is firmly committed under a purchase contract
to b_y one million barrels of crude oil at a fixed pr___
Another example,
a refinery, concerned that crude prices may fall
while it is firmly committed under a purchase contract
to buy one million barrels of crude oil at a fixed price
Another example,
a refinery, con____ed that crude prices may fall
while it is firmly committed under a purchase contract
to buy one million barrels of crude oil at a fixed price
Another example,
a refinery, concerned that crude prices may fall
while it is firmly committed under a purchase contract
to buy one million barrels of crude oil at a fixed price
Another example,
a refinery, concerned that crude prices may fall
while it is firmly com____ed under a purchase contract
to b_y one million barrels of crude oil at a f__ed price
Another example,
a refinery, concerned that crude prices may fall
while it is firmly committed under a purchase contract
to buy one million barrels of crude oil at a fixed price
Another example,
a refinery, concerned that crude prices may fall
while it is firmly committed under a purchase contract
to buy one million barrels of crude oil at a fixed price
in the fut___, would sell a crude oil futures contract.
Another example,
a refinery, concerned that crude prices may fall
while it is firmly committed under a purchase contract
to buy one million barrels of crude oil at a fixed price
in the future, would sell a crude oil futures contract.
Another example,
a refinery, concerned that crude prices may fall
while it is firmly committed under a purchase contract
to buy one million barrels of crude oil at a fixed price
in the future, would sell a crude oil fut___s contract.
Another example,
a refinery, concerned that crude prices may fall
while it is firmly committed under a purchase contract
to buy one million barrels of crude oil at a fixed price
in the future, would sell a crude oil futures contract.
Another example,
a refinery, concerned that crude prices may fall
while it is firmly committed under a purchase contract
to buy one million barrels of crude oil at a fixed price
in the future, would s__l a crude oil fu____s contract.
Another example,
a refinery, concerned that crude prices may fall
while it is firmly committed under a purchase contract
to buy one million barrels of crude oil at a fixed price
in the future, would sell a crude oil futures contract.
Another example,
a refinery, concerned that crude prices may fall
while it is firmly committed under a purchase contract
to buy one million barrels of crude oil at a fixed price
in the future, would s__l a crude oil futures con____t.
Another example,
a refinery, concerned that crude prices may fall
while it is firmly committed under a purchase contract
to buy one million barrels of crude oil at a fixed price
in the future, would sell a crude oil futures contract.
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be con____ually obligated to pay an above-market price
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually ob____ed to p_y an above-market price
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an ab___-market price
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be co______ually obligated to pay an above-market pr___ under its purchase contract,
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a g__n in the value of its futures contract
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would r___ize a gain in the va___ of its futures contract
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its fu___es contract that effectively reimburses the entity
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that eff______ly reimburses the entity
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity as
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reim_____s the entity as if it had purchased the crude at the lo___ hedged market price.
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity as if it had purchased the crude at the lower hedged market price.
Another example,
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity as
if it h__ purchased the crude at the lower hedged market price.
Another example,
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity as
if it had purchased the crude at the lower hedged market price.
Another example,
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity as
if it had pur____ed the crude at the lower hedged market price.
Another example,
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity as
if it had purchased the crude at the lower hedged market price.
Another example,
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity as
if it had purchased the crude at the lo___ hedged market price.
Another example,
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity as
if it had purchased the crude at the lower hedged market price.
Another example,
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity as
if it had purchased the crude at the lower he__ed market price.
Another example,
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity as
if it had purchased the crude at the lower hedged market price.
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity as if it had purchased the crude at the lower hedged market price.
However, if crude oil prices increase,
the l__s on the futures contract will result in the refinery paying an effective cost over and above the fixed purchase contract price.
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity as if it had purchased the crude at the lower hedged market price.
However, if crude oil prices increase,
the loss on the futures contract will result in the refinery paying an effective cost over and above the fixed purchase contract price.
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
However, if crude oil prices in_____e,
the loss on the futures contract
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
However, if crude oil prices increase,
the loss on the futures contract
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
However, if crude oil prices increase,
the loss on the fu____s contract
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
However, if crude oil prices increase,
the loss on the futures contract
Another example,
However, if crude oil prices increase,
the loss on the futures cont____
will result in the refinery p__ing an effective cost
Another example,
However, if crude oil prices increase,
the loss on the futures contract
will result in the refinery paying an effective cost
Another example,
However, if crude oil prices increase,
the loss on the futures contract
will result in the refinery paying an effe_____ cost
Another example,
However, if crude oil prices increase,
the loss on the futures contract
will result in the refinery paying an effective cost
Another example,
However, if crude oil prices increase,
the loss on the futures contract
will res___ in the refinery paying an effective cost
Another example,
However, if crude oil prices increase,
the loss on the futures contract
will result in the refinery paying an effective cost
Another example,
However, if crude oil prices increase,
the loss on the futures contract
will result in the refinery paying an effective cost
ov__ and above the fixed purchase contract price.
Another example,
However, if crude oil prices increase,
the loss on the futures contract
will result in the refinery paying an effective cost
over and above the fixed purchase contract price.
Another example,
However, if crude oil prices increase,
the loss on the futures contract
will result in the refinery paying an effective cost
over and ab___ the fixed purchase contract price.
Another example,
However, if crude oil prices increase,
the loss on the futures contract
will result in the refinery paying an effective cost
over and above the fixed purchase contract price.
Another example,
However, if crude oil prices increase,
the loss on the futures contract
will result in the refinery paying an effective cost
over and above the f__ed purchase contract price.
Another example,
However, if crude oil prices increase,
the loss on the futures contract
will result in the refinery paying an effective cost
over and above the fixed purchase contract price.
Another example,
However, if crude oil prices increase,
the loss on the futures contract
will result in the refinery paying an effective cost
over and above the fixed purchase cont____ price.
Another example,
However, if crude oil prices increase,
the loss on the futures contract
will result in the refinery paying an effective cost
over and above the fixed purchase contract price.
Another example,
However, if crude oil prices increase,
the loss on the futures contract
will result in the refinery paying an effective cost
over and above the fixed purc____ contract pr___.
Another example,
However, if crude oil prices increase,
the loss on the futures contract
will result in the refinery paying an effective cost
over and above the fixed purchase contract price.
Another example,
a refinery, con____ed that crude p___es may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity as if it had purchased the crude at the lower hedged market price.
However, if crude oil prices increase,
the loss on the futures contract will result in the refinery paying an effective cost over and above the fixed purchase contract price.
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity as if it had purchased the crude at the lower hedged market price.
However, if crude oil prices increase,
the loss on the futures contract will result in the refinery paying an effective cost over and above the fixed purchase contract price.
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually ob____ed to p_y an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity as if it had purchased the crude at the lower hedged market price.
However, if crude oil prices increase,
the loss on the futures contract will result in the refinery paying an effective cost over and above the fixed purchase contract price.
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity as if it had purchased the crude at the lower hedged market price.
However, if crude oil prices increase,
the loss on the futures contract will result in the refinery paying an effective cost over and above the fixed purchase contract price.
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity as if it had purchased the crude at the lower hedged market price.
However, if crude oil prices increase,
the loss on the fut___s contract will result in the refinery paying an effective cost over and above the fixed purchase contract price.
Another example,
a refinery, concerned that crude prices may fall while it is firmly committed under a purchase contract to buy one million barrels of crude oil at a fixed price in the future, would sell a crude oil futures contract.
If prices decrease,
the entity will be contractually obligated to pay an above-market price under its purchase contract,
but would realize a gain in the value of its futures contract that effectively reimburses the entity as if it had purchased the crude at the lower hedged market price.
However, if crude oil prices increase,
the loss on the futures contract will result in the refinery paying an effective cost over and above the fixed purchase contract price.
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, respectively, were fixed.
The derivatives effectively unlocked the fixed terms of both the fixed-rate debt and
the firm purchase commitment to buy crude oil,
and exposed the entities’ earnings to subsequent favorable and unfavorable
changes in value of the hedged items
attributable to changes in interest rates and market prices, respectively.
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, respectively, were fixed.
The derivatives effectively unlocked the fixed terms of
both the fixed-rate debt and
the firm purchase commitment to buy crude oil,
and exposed the entities’ earnings to subsequent favorable and unfavorable
changes in value of the hedged items
attributable to changes in interest rates and market prices, respectively.
Fair Value Hedge
In both of the previous examples,
the entities’ fut___ cash flows to pay interest and buy crude oil, were fixed.
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, were fixed.
Fair Value Hedge
In both of the previous examples,
the entities’ future ch flows to p_y interest and buy crude oil, were fixed.
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, were fixed. de oil,
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and b_y crude oil, were fixed.
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, were fixed.
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, were f__ed.
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, were fixed.
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, were fixed.
The de______s effectively unlocked the fixed terms
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, were fixed.
The derivatives effectively unlocked the fixed terms
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, were fixed.
The derivatives ef_______ly unlocked the fixed terms
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, were fixed.
The derivatives effectively unlocked the fixed terms
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, were fixed.
The derivatives effectively un____ed the fixed terms
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, were fixed.
The derivatives effectively unlocked the fixed terms
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, were fixed.
The derivatives effectively unlocked the f__ed terms
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, were fixed.
The derivatives effectively unlocked the fixed terms
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, were fixed.
The derivatives effectively unlocked the fixed t__ms of both the fixed-rate debt
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, were fixed.
The derivatives effectively unlocked the fixed terms of both the fixed-rate debt
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, were fixed.
The derivatives effectively unlocked the fixed terms of both the fixed-rate d__t
and the firm purchase com_______ to buy crude oil,
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, were fixed.
The derivatives effectively unlocked the fixed terms of both the fixed-rate debt
and the firm purchase commitment to buy crude oil,
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, were fixed.
The derivatives effectively unlocked the fixed terms of both the fixed-rate debt
and the firm pur_____ commitment to buy crude oil,
Fair Value Hedge
In both of the previous examples,
the entities’ future cash flows to pay interest and buy crude oil, were fixed.
The derivatives effectively unlocked the fixed terms of both the fixed-rate debt
and the firm purchase commitment to buy crude oil,
