AUD 3 Internal Control 16 - 8 Investing and Financing Cycle - Derivatives and Hedge Accounting (Examples) Flashcards
1
Q
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
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.
2
Q
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.
A
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.
3
Q
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
A
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
4
Q
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
A
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
5
Q
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.
A
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.
6
Q
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
A
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
7
Q
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
A
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
8
Q
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,
A
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,
9
Q
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,
A
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,
10
Q
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,
A
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,
11
Q
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.
A
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.
12
Q
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__.
A
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.
13
Q
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.
A
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.
14
Q
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.
A
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.
15
Q
Interest Rate Swap
Example
An entity with fixed-rate d__t ent__s into an interest rate swap
A
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap
16
Q
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an inte____ rate sw__ to receive a fixed rate
A
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate
17
Q
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
A
Interest Rate Swap
Example
An entity with fixed-rate debt enters into an interest rate swap to receive a fixed rate of interest
18
Q
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
A
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
19
Q
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
A
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
20
Q
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
A
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
21
Q
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
A
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
22
Q
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
A
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
23
Q
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
A
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
24
Q
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
A
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
25
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.
26
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.
27
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.
28
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.
29
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%)
30
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.
31
Another example,
a refinery, concerned that crude pr__es may fall
Another example,
a refinery, concerned that crude prices may fall
32
Another example,
a refinery, concerned that crude prices may f__l
Another example,
a refinery, concerned that crude prices may fall
33
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
34
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
35
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
36
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
37
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
38
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
39
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.
40
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.
41
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.
42
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.
43
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
44
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
45
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
46
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,
47
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
48
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
49
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
50
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
51
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.
52
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.
53
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.
54
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.
55
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.
56
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.
57
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
58
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
59
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
60
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
61
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
62
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.
63
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.
64
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.
65
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.
66
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.
67
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.
68
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.
69
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.
70
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.
71
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.
72
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,
73
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.
74
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.
75
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
76
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
77
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
78
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
79
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
80
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,
81
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,
82
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 ex____d the entities’ earnings
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
83
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’ e___ings to subsequent favorable and unfavorable
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
84
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 sub______ favorable and unfavorable
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
85
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 favo_____ and unfavorable
changes in value of the hedged items
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
86
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 unfa________
changes in value of the hedged items
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
87
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
cha___s in value of the hedged items
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
88
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 va___ of the hedged items
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
89
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 he___d items
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
90
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 it__s
attributable to changes in interest rates and market prices
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.
91
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
att______ble to changes in interest rates and market prices.
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.
92
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 ch___es in interest rates and market prices.
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.
93
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 r___s and market prices.
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.
94
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 pri__s.
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.
95
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.
Except for foreign currency fair value hedges,
the derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate or index.
However, because of the unlocking of the fixed terms, the entity’s earnings may also be exposed to unfavorable changes.
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.
Except for foreign currency fair value hedges,
the derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate or index.
However, because of the unlocking of the fixed terms, the entity’s earnings may also be exposed to unfavorable changes.
96
Fair Value Hedge
Except for foreign currency fair value hedges,
the derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate or index.
However, because of the unlocking of the fixed terms, the entity’s earnings may also be exposed to unfavorable changes.
Fair Value Hedge
Except for foreign currency fair value hedges,
the derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate or index.
However, because of the unlocking of the fixed terms, the entity’s earnings may also be exposed to unfavorable changes.
97
Fair Value Hedge
The der________ in a fair value hedge
Fair Value Hedge
The derivative in a fair value hedge
98
Fair Value Hedge
The derivative in a fair value he___ will unlock a price,
Fair Value Hedge
The derivative in a fair value hedge will unlock a price,
99
Fair Value Hedge
The derivative in a fair value hedge will un____ a price, rate,
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate,
100
Fair Value Hedge
The derivative in a fair value hedge will unlock a p____, rate, or index
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index
101
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, r___, or index
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index
102
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or in___
that would otherwise be fixed
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index
that would otherwise be fixed
103
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index
that would otherwise be fi_ed or locked
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index
that would otherwise be fixed or locked
104
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index
that would otherwise be fixed or l__ked from the entity’s income statement perspective.
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index
that would otherwise be fixed or locked from the entity’s income statement perspective.
105
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index
that would otherwise be fixed or locked from the entity’s income statement pers_______.
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index
that would otherwise be fixed or locked from the entity’s income statement perspective.
106
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s in____ statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate or index.
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate or index.
107
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the der______ unlocks the fixed terms,
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
108
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative un____s the fixed terms,
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
109
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the f__ed terms,
the entity’s income statement
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement
110
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s in____ statement benefits from favorable changes in the price
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price
111
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement b____its from favorable changes in the price, rate
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate
112
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from fa______le changes in the price, rate
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate
113
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable ch____s in the price, rate or index.
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate or index.
114
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the pr___, rate or index.
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate or index.
115
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate or index.
However, because of the un____ing of the fixed terms,
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate or index.
However, because of the unlocking of the fixed terms,
116
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate or index.
However, because of the unlocking of the f__ed terms, the entity’s earnings
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate or index.
However, because of the unlocking of the fixed terms, the entity’s earnings
117
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate or index.
However, because of the unlocking of the fixed terms, the entity’s e___ings may also be exposed to unfavorable changes.
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate or index.
However, because of the unlocking of the fixed terms, the entity’s earnings may also be exposed to unfavorable changes.
118
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate or index.
However, because of the unlocking of the fixed terms, the entity’s earnings may also be ex____d to unfavorable changes.
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate or index.
However, because of the unlocking of the fixed terms, the entity’s earnings may also be exposed to unfavorable changes.
119
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate or index.
However, because of the unlocking of the fixed terms, the entity’s earnings may also be exposed to unfa______ changes.
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate or index.
However, because of the unlocking of the fixed terms, the entity’s earnings may also be exposed to unfavorable changes.
120
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate or index.
However, because of the unlocking of the fixed terms, the entity’s earnings may also be exposed to unfavorable ch____s.
Fair Value Hedge
The derivative in a fair value hedge will unlock a price, rate, or index that would otherwise be fixed or locked from the entity’s income statement perspective.
Once the derivative unlocks the fixed terms,
the entity’s income statement benefits from favorable changes in the price, rate or index.
However, because of the unlocking of the fixed terms, the entity’s earnings may also be exposed to unfavorable changes.
121
Fair Value Hedge
Examples of f__r value hedges of assets work similarly.
An entity that owns inventory could enter into a fair value hedge to protect the value of its inventory on hand,
Fair Value Hedge
Examples of fair value hedges of assets work similarly.
An entity that owns inventory could enter into a fair value hedge to protect the value of its inventory on hand,
122
Fair Value Hedge
Examples of fair value hedges of assets work similarly.
An entity that owns inv_____ry could en___ into a fair value hedge to protect the value of its inventory on hand,
Fair Value Hedge
Examples of fair value hedges of assets work similarly.
An entity that owns inventory could enter into a fair value hedge to protect the value of its inventory on hand,
123
Fair Value Hedge
Examples of fair value hedges of assets work similarly.
An entity that owns inventory could enter into a fair value hedge to pro____ the val__ of its inventory on hand,
Fair Value Hedge
Examples of fair value hedges of assets work similarly.
An entity that owns inventory could enter into a fair value hedge to protect the value of its inventory on hand,
124
Fair Value Hedge
Examples of fair value hedges of assets work similarly.
An entity that owns inventory could enter into a fair value hedge to protect the value of its in______ry on hand,
and an entity that has an investment in an available-for-sale fixed-rate debt instrument could enter into an interest rate swap to synthetically convert the fixed-rate debt instrument to a variable-rate debt instrument.
Fair Value Hedge
Examples of fair value hedges of assets work similarly.
An entity that owns inventory could enter into a fair value hedge to protect the value of its inventory on hand,
and an entity that has an investment in an available-for-sale fixed-rate debt instrument could enter into an interest rate swap to synthetically convert the fixed-rate debt instrument to a variable-rate debt instrument.
125
Fair Value Hedge
Examples of fair value hedges of assets work similarly.
An entity that owns inventory could enter into a fair value hedge to protect the value of its inventory on hand,
and an entity that has an invest____ in an available-for-sale fixed-rate debt instrument
could enter into an interest rate swap to synthetically convert the fixed-rate debt instrument to a variable-rate debt instrument.
Fair Value Hedge
Examples of fair value hedges of assets work similarly.
An entity that owns inventory could enter into a fair value hedge to protect the value of its inventory on hand,
and an entity that has an investment in an available-for-sale fixed-rate debt instrument
could enter into an interest rate swap to synthetically convert the fixed-rate debt instrument to a variable-rate debt instrument.
126
Fair Value Hedge
Examples of fair value hedges of assets work similarly.
An entity that owns inventory could enter into a fair value hedge to protect the value of its inventory on hand,
and an entity that has an investment in an available-for-sale fixed-rate debt instrument
could enter into an interest rate s__p to synthetically conv___ the fixed-rate debt instrument to a variable-rate debt instrument.
Fair Value Hedge
Examples of fair value hedges of assets work similarly.
An entity that owns inventory could enter into a fair value hedge to protect the value of its inventory on hand,
and an entity that has an investment in an available-for-sale fixed-rate debt instrument
could enter into an interest rate swap to synthetically convert the fixed-rate debt instrument to a variable-rate debt instrument.
127
Fair Value Hedge
Examples of fair value hedges of assets work similarly.
An entity that owns inventory could enter into a fair value hedge to protect the value of its inventory on hand,
and an entity that has an investment in an available-for-sale f__ed-rate debt inst________ could enter into an interest rate swap to synthetically convert the fixed-rate debt instrument to a variable-rate debt instrument.
Fair value hedges protect against exposures to changes in the fair value of a recognized asset (e.g., inventory, fixed-rate notes receivable, fixed-rate bond), liability (e.g., fixed-rate debt issuance), or unrecognized firm commitment.
Fair Value Hedge
Examples of fair value hedges of assets work similarly.
An entity that owns inventory could enter into a fair value hedge to protect the value of its inventory on hand,
and an entity that has an investment in an available-for-sale fixed-rate debt instrument could enter into an interest rate swap to synthetically convert the fixed-rate debt instrument to a variable-rate debt instrument.
Fair value hedges protect against exposures to changes in the fair value of a recognized asset (e.g., inventory, fixed-rate notes receivable, fixed-rate bond), liability (e.g., fixed-rate debt issuance), or unrecognized firm commitment.
128
Fair Value Hedge
Fair value hedges protect against expo____s to changes in the fair value of
- a recognized asset,
- a recognized liability, or
- unrecognized firm commitment.
Fair Value Hedge
Fair value hedges protect against exposures to changes in the fair value of
- a recognized asset,
- a recognized liability, or
- unrecognized firm commitment.
129
Fair Value Hedge
Fair value hedges pro____ against exposures to changes in the fair value of
- a recognized asset,
- a recognized liability, or
- unrecognized firm commitment.
Fair Value Hedge
Fair value hedges protect against exposures to changes in the fair value of
- a recognized asset,
- a recognized liability, or
- unrecognized firm commitment.
130
Fair Value Hedge
Fair value hedges protect against exposures to changes in the fair value of
- a recognized as___,
- a recognized liability, or
- unrecognized firm commitment.
Fair Value Hedge
Fair value hedges protect against exposures to changes in the fair value of
- a recognized asset,
- a recognized liability, or
- unrecognized firm commitment.
131
Fair Value Hedge
Fair value hedges protect against exposures to changes in the fair value of
- a recognized asset,
- a recognized li_____ty, or
- unrecognized firm commitment.
Fair Value Hedge
Fair value hedges protect against exposures to changes in the fair value of
- a recognized asset,
- a recognized liability, or
- unrecognized firm commitment.
132
Fair Value Hedge
Fair value hedges protect against exposures to changes in the fair value of
- a recognized asset,
- a recognized liability, or
- unrecognized firm com______nt.
Fair Value Hedge
Fair value hedges protect against exposures to changes in the fair value of
- a recognized asset,
- a recognized liability, or
- unrecognized firm commitment.
133
Fair Value Hedge
Fair value hedges protect against exposures to changes in the fair value of
- a recognized asset,
- a recognized liability, or
- unrecognized firm commitment.
recognized asset
(e.g., inventory, fixed-rate notes rec______le, fixed-rate bond),
recognized liability
(e.g., fixed-rate debt issuance),
Fair Value Hedge
Fair value hedges protect against exposures to changes in the fair value of
- a recognized asset,
- a recognized liability, or
- unrecognized firm commitment.
recognized asset
(e.g., inventory, fixed-rate notes receivable, fixed-rate bond),
recognized liability
(e.g., fixed-rate debt issuance),
134
Fair Value Hedge
Fair value hedges protect against exposures to changes in the fair value of
- a recognized asset,
- a recognized liability, or
- unrecognized firm commitment.
recognized asset
(e.g., inventory, fixed-rate notes receivable, fixed-rate b__d),
recognized liability
(e.g., fixed-rate debt issuance),
Fair Value Hedge
Fair value hedges protect against exposures to changes in the fair value of
- a recognized asset,
- a recognized liability, or
- unrecognized firm commitment.
recognized asset
(e.g., inventory, fixed-rate notes receivable, fixed-rate bond),
recognized liability
(e.g., fixed-rate debt issuance),
135
Fair Value Hedge
Fair value hedges protect against exposures to changes in the fair value of
- a recognized asset,
- a recognized liability, or
- unrecognized firm commitment.
recognized asset
(e.g., inventory, fixed-rate notes receivable, fixed-rate bond),
recognized liability
(e.g., fixed-rate d__t issuance),
Fair Value Hedge
Fair value hedges protect against exposures to changes in the fair value of
- a recognized asset,
- a recognized liability, or
- unrecognized firm commitment.
recognized asset
(e.g., inventory, fixed-rate notes receivable, fixed-rate bond),
recognized liability
(e.g., fixed-rate debt issuance),
136
Fair Value Hedge
Fair value hedges protect against exposures to changes in the fair value of
- a recognized asset,
- a recognized liability, or
- unrecognized firm commitment.
recognized asset
(e.g., inv-___ory, fixed-rate notes receivable, fixed-rate bond),
recognized liability
(e.g., fixed-rate debt issuance),
Fair Value Hedge
Fair value hedges protect against exposures to changes in the fair value of
- a recognized asset,
- a recognized liability, or
- unrecognized firm commitment.
recognized asset
(e.g., inventory, fixed-rate notes receivable, fixed-rate bond),
recognized liability
(e.g., fixed-rate debt issuance),
137
Firm commitments
ASC 815 defines a firm commitment as
an agreement with an unrelated p__ty, binding on both parties, and usually legally enforceable,
Firm commitments
ASC 815 defines a firm commitment as
an agreement with an unrelated party, binding on both parties, and usually legally enforceable,
138
Firm commitments
ASC 815 defines a firm commitment as
an agree____ with an unrelated party, binding on both parties, and usually legally enforceable,
Firm commitments
ASC 815 defines a firm commitment as
an agreement with an unrelated party, binding on both parties, and usually legally enforceable,
139
Firm commitments
ASC 815 defines a firm commitment as an agreement with an unrelated party, binding on both parties, and usually legally enforceable, with the following characteristics:
• The agreement sp____ies all significant terms, including
- the quantity to be exchanged,
- the fixed price and
- the timing of the transaction.
Firm commitments
ASC 815 defines a firm commitment as an agreement with an unrelated party, binding on both parties, and usually legally enforceable, with the following characteristics:
• The agreement specifies all significant terms, including
- the quantity to be exchanged,
- the fixed price and
- the timing of the transaction.
140
Firm commitments
ASC 815 defines a firm commitment as an agreement with an unrelated party, binding on both parties, and usually legally enforceable, with the following characteristics:
• The agreement specifies all sig_______ terms, including
- the quantity to be exchanged,
- the fixed price and
- the timing of the transaction.
Firm commitments
ASC 815 defines a firm commitment as an agreement with an unrelated party, binding on both parties, and usually legally enforceable, with the following characteristics:
• The agreement specifies all significant terms, including
- the quantity to be exchanged,
- the fixed price and
- the timing of the transaction.
141
Firm commitments
ASC 815 defines a firm commitment as an agreement with an unrelated party, binding on both parties, and usually legally enforceable, with the following characteristics:
• The agreement specifies all significant terms, including
- the q____ity to be exchanged,
- the fixed pr___ and
- the timing of the transaction.
Firm commitments
ASC 815 defines a firm commitment as an agreement with an unrelated party, binding on both parties, and usually legally enforceable, with the following characteristics:
• The agreement specifies all significant terms, including
- the quantity to be exchanged,
- the fixed price and
- the timing of the transaction.
142
Firm commitments
ASC 815 defines a firm commitment as an agreement with an unrelated party, binding on both parties, and usually legally enforceable, with the following characteristics:
• The agreement specifies all significant terms, including
- the quantity to be exchanged,
- the fixed price and
- the t__ing of the trans_______.
The fixed price may be expressed as a specified amount of an entity’s functional currency or of a foreign currency.
Firm commitments
ASC 815 defines a firm commitment as an agreement with an unrelated party, binding on both parties, and usually legally enforceable, with the following characteristics:
• The agreement specifies all significant terms, including
- the quantity to be exchanged,
- the fixed price and
- the timing of the transaction.
The fixed price may be expressed as a specified amount of an entity’s functional currency or of a foreign currency.
143
Firm commitments
ASC 815 defines a firm commitment as an agreement with an unrelated party, binding on both parties, and usually legally enforceable, with the following characteristics:
• The agreement specifies all significant terms, including
- the quantity to be exchanged,
- the fixed price and
- the timing of the transaction.
The f__ed price may be expressed as a specified amo___ of an entity’s functional currency or of a foreign currency.
It may also be expressed as a specified interest r__e or specified effective yield.
Firm commitments
ASC 815 defines a firm commitment as an agreement with an unrelated party, binding on both parties, and usually legally enforceable, with the following characteristics:
• The agreement specifies all significant terms, including
- the quantity to be exchanged,
- the fixed price and
- the timing of the transaction.
The fixed price may be expressed as a specified amount of an entity’s functional currency or of a foreign currency.
It may also be expressed as a specified interest rate or specified effective yield.
144
Firm commitments
ASC 815 defines a firm commitment as an agreement with an unrelated party, binding on both parties, and usually legally enforceable, with the following characteristics:
• The agreement specifies all significant terms, including
- the quantity to be exchanged,
- the fixed price and
- the timing of the transaction.
The fixed price may be expressed as a specified amount of an entity’s functional currency or of a foreign currency.
It may also be expressed as a specified interest rate or specified effective y___d.
• The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable.
Firm commitments
ASC 815 defines a firm commitment as an agreement with an unrelated party, binding on both parties, and usually legally enforceable, with the following characteristics:
• The agreement specifies all significant terms, including
- the quantity to be exchanged,
- the fixed price and
- the timing of the transaction.
The fixed price may be expressed as a specified amount of an entity’s functional currency or of a foreign currency.
It may also be expressed as a specified interest rate or specified effective yield.
• The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable.
145
Firm commitments
ASC 815 defines a firm commitment as an agreement with an unrelated party, binding on both parties, and usually legally enforceable, with the following characteristics:
• The agreement specifies all significant terms, including
- the quantity to be exchanged,
- the fixed price and
- the timing of the transaction.
The fixed price may be expressed as a specified amount of an entity’s functional currency or of a foreign currency.
It may also be expressed as a specified interest rate or specified effective yield.
• The agr________ includes a disincentive for nonperformance that is sufficiently large to make performance probable.
Firm commitments
ASC 815 defines a firm commitment as an agreement with an unrelated party, binding on both parties, and usually legally enforceable, with the following characteristics:
• The agreement specifies all significant terms, including
- the quantity to be exchanged,
- the fixed price and
- the timing of the transaction.
The fixed price may be expressed as a specified amount of an entity’s functional currency or of a foreign currency.
It may also be expressed as a specified interest rate or specified effective yield.
• The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable.
146
Firm commitments
ASC 815 defines a firm commitment as an agreement with an unrelated party, binding on both parties, and usually legally enforceable, with the following characteristics:
• The agreement specifies all significant terms, including
- the quantity to be exchanged,
- the fixed price and
- the timing of the transaction.
The fixed price may be expressed as a specified amount of an entity’s functional currency or of a foreign currency.
It may also be expressed as a specified interest rate or specified effective yield.
• The agreement includes a disincentive for nonperf_________ that is sufficiently large to make performance probable.
Firm commitments
ASC 815 defines a firm commitment as an agreement with an unrelated party, binding on both parties, and usually legally enforceable, with the following characteristics:
• The agreement specifies all significant terms, including
- the quantity to be exchanged,
- the fixed price and
- the timing of the transaction.
The fixed price may be expressed as a specified amount of an entity’s functional currency or of a foreign currency.
It may also be expressed as a specified interest rate or specified effective yield.
• The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable.
147
Firm commitments
ASC 815 defines a firm commitment as an agreement with an unrelated party, binding on both parties, and usually legally enforceable, with the following characteristics:
• The agreement specifies all significant terms, including
- the quantity to be exchanged,
- the fixed price and
- the timing of the transaction.
The fixed price may be expressed as a specified amount of an entity’s functional currency or of a foreign currency.
It may also be expressed as a specified interest rate or specified effective yield.
• The agreement includes a disincentive for nonperformance that is sufficiently large to make performance pro___le.
Firm commitments
ASC 815 defines a firm commitment as an agreement with an unrelated party, binding on both parties, and usually legally enforceable, with the following characteristics:
• The agreement specifies all significant terms, including
- the quantity to be exchanged,
- the fixed price and
- the timing of the transaction.
The fixed price may be expressed as a specified amount of an entity’s functional currency or of a foreign currency.
It may also be expressed as a specified interest rate or specified effective yield.
• The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable.
148
Firm commitment examples:
Examples of contractual commit____s satisfying the definition of a firm commitment include:
• A commodity purchase agreement
Firm commitment examples:
Examples of contractual commitments satisfying the definition of a firm commitment include:
• A commodity purchase agreement
149
Firm commitment examples:
Examples of contractual commitments satisfying the definition of a firm commitment include:
• A com___ity purchase agreement
Firm commitment examples:
Examples of contractual commitments satisfying the definition of a firm commitment include:
• A commodity purchase agreement t
150
Firm commitment examples:
• A commodity purchase agreement that provides for a f__ed quantity to be delivered at a f__ed price with specified timing
Firm commitment examples:
• A commodity purchase agreement that provides for a fixed quantity to be delivered at a fixed price with specified timing
151
Firm commitment examples:
• A commodity purchase agreement that provides for a fixed q____ity to be delivered at a fixed pr___ with specified timing
Firm commitment examples:
• A commodity purchase agreement that provides for a fixed quantity to be delivered at a fixed price with specified timing
152
Firm commitment examples:
• A commodity purchase agreement that provides for a fixed quantity to be delivered at a fixed price with specified t__ing
Firm commitment examples:
• A commodity purchase agreement that provides for a fixed quantity to be delivered at a fixed price with specified timing
153
Firm commitment examples:
* A commodity purchase agreement that provides for a fixed quantity to be delivered at a fixed price with specified timing
* A contract for the pu____se of equipment
Firm commitment examples:
* A commodity purchase agreement that provides for a fixed quantity to be delivered at a fixed price with specified timing
* A contract for the purchase of equipment
154
Firm commitment examples:
• A contract for the purchase of equipment on a specified delivery da__ at a fixed price denominated in a foreign currency
Firm commitment examples:
• A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a foreign currency
155
Firm commitment examples:
• A contract for the purchase of equipment on a specified delivery date at a f__ed price denominated in a foreign currency
Firm commitment examples:
• A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a foreign currency
156
Firm commitment examples:
• A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a foreign currency
Firm commitment examples:
• A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a foreign currency
157
Firm commitment examples:
• A contract for the purchase of equipment on a specified de______y date at a fixed price denominated in a foreign currency
Firm commitment examples:
• A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a foreign currency
158
Firm commitment examples:
• A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a for____ currency
Firm commitment examples:
• A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a foreign currency
159
Firm commitment examples:
• A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a foreign currency
(In this case, the exchange rate is not fixed, but the foreign cur___cy amount is.)
Firm commitment examples:
• A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a foreign currency
(In this case, the exchange rate is not fixed, but the foreign currency amount is.)
160
Firm commitment examples:
• A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a foreign currency
(In this case, the exchange rate is not fixed, but the foreign currency a____t is.)
• A license or royalty agreement
Firm commitment examples:
• A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a foreign currency
(In this case, the exchange rate is not fixed, but the foreign currency amount is.)
• A license or royalty agreement
161
Firm commitment examples:
• A license or royalty agre_______ that provides for fixed periodic payments at specific time intervals
Firm commitment examples:
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
162
Firm commitment examples:
• A lic____e or roy___y agreement that provides for fixed periodic payments at specific time intervals
Firm commitment examples:
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
163
Firm commitment examples:
• A license or royalty agreement that pro___es for f__ed periodic payments at specific time intervals
Firm commitment examples:
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
164
Firm commitment examples:
• A license or royalty agreement that provides for fixed periodic pa_____ts at specific time intervals
Firm commitment examples:
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
165
Firm commitment examples:
• A license or royalty agreement that provides for fixed per______ payments at specific time inte____s
Firm commitment examples:
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
166
Firm commitment examples:
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
Firm commitment examples:
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
167
Firm commitment examples:
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does n_t include a minimum or f__ed quantity
would n__ meet the definition of a firm commitment
Firm commitment examples:
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment
168
Firm commitment examples:
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a min____ or fixed q____ity
would not meet the definition of a firm commitment
Firm commitment examples:
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment
169
Firm commitment examples:
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the defi_______ of a firm comm______
Firm commitment examples:
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment
170
Firm commitment examples:
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment even though fu_____ sales that will result in the royalty payments are pro___le.
Firm commitment examples:
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment even though future sales that will result in the royalty payments are probable.
171
Firm commitment examples:
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment even though future sales that will result in the royalty payments are probable.
It may, however, qualify as a forecasted tran______.)
Firm commitment examples:
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment even though future sales that will result in the royalty payments are probable.
It may, however, qualify as a forecasted transaction.)
172
Firm commitment examples:
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment even though future sales that will result in the royalty payments are probable.
It may, however, qualify as a fore____ed transaction.)
Firm commitment examples:
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment even though future sales that will result in the royalty payments are probable.
It may, however, qualify as a forecasted transaction.)
173
Firm commitment examples:
Examples of contractual commitments satisfying the definition of a firm commitment include:
* A commodity purchase agreement that provides for a f__ed q_____ity to be delivered at a fixed price with specified timing
* A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a foreign currency
(In this case, the exchange rate is not fixed, but the foreign currency amount is.)
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment
even though future sales that will result in the royalty payments are probable.
It may, however, qualify as a forecasted transaction.)
Firm commitment examples:
Examples of contractual commitments satisfying the definition of a firm commitment include:
* A commodity purchase agreement that provides for a fixed quantity to be delivered at a fixed price with specified timing
* A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a foreign currency
(In this case, the exchange rate is not fixed, but the foreign currency amount is.)
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment
even though future sales that will result in the royalty payments are probable.
It may, however, qualify as a forecasted transaction.)
174
Firm commitment examples:
Examples of contractual commitments satisfying the definition of a firm commitment include:
* A commodity purchase agreement that provides for a fixed quantity to be delivered at a fixed price with specified timing
* A contract for the purchase of equipment on a specified delivery date at a f__ed pr___ denominated in a foreign currency
(In this case, the exchange rate is not fixed, but the foreign currency amount is.)
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment
even though future sales that will result in the royalty payments are probable.
It may, however, qualify as a forecasted transaction.)
Firm commitment examples:
Examples of contractual commitments satisfying the definition of a firm commitment include:
* A commodity purchase agreement that provides for a fixed quantity to be delivered at a fixed price with specified timing
* A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a foreign currency
(In this case, the exchange rate is not fixed, but the foreign currency amount is.)
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment
even though future sales that will result in the royalty payments are probable.
It may, however, qualify as a forecasted transaction.)
175
Firm commitment examples:
Examples of contractual commitments satisfying the definition of a firm commitment include:
* A commodity purchase agreement that provides for a fixed quantity to be delivered at a fixed price with specified timing
* A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a foreign currency
(In this case, the exchange rate is not fixed, but the foreign cu____cy am___t is.)
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment
even though future sales that will result in the royalty payments are probable.
It may, however, qualify as a forecasted transaction.)
Firm commitment examples:
Examples of contractual commitments satisfying the definition of a firm commitment include:
* A commodity purchase agreement that provides for a fixed quantity to be delivered at a fixed price with specified timing
* A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a foreign currency
(In this case, the exchange rate is not fixed, but the foreign currency amount is.)
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment
even though future sales that will result in the royalty payments are probable.
It may, however, qualify as a forecasted transaction.)
176
Firm commitment examples:
Examples of contractual commitments satisfying the definition of a firm commitment include:
* A commodity purchase agreement that provides for a fixed quantity to be delivered at a fixed price with specified timing
* A contract for the purchase of equipment on a sp____ied delivery da__ at a fixed price denominated in a foreign currency
(In this case, the exchange rate is not fixed, but the foreign currency amount is.)
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment
even though future sales that will result in the royalty payments are probable.
It may, however, qualify as a forecasted transaction.)
Firm commitment examples:
Examples of contractual commitments satisfying the definition of a firm commitment include:
* A commodity purchase agreement that provides for a fixed quantity to be delivered at a fixed price with specified timing
* A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a foreign currency
(In this case, the exchange rate is not fixed, but the foreign currency amount is.)
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment
even though future sales that will result in the royalty payments are probable.
It may, however, qualify as a forecasted transaction.)
177
Firm commitment examples:
Examples of contractual commitments satisfying the definition of a firm commitment include:
* A commodity purchase agreement that provides for a fixed quantity to be delivered at a fixed price with specified timing
* A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a foreign currency
(In this case, the exchange rate is not fixed, but the foreign currency amount is.)
• A license or royalty agreement that provides for f___d periodic pa____ts at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment
even though future sales that will result in the royalty payments are probable.
It may, however, qualify as a forecasted transaction.)
Firm commitment examples:
Examples of contractual commitments satisfying the definition of a firm commitment include:
* A commodity purchase agreement that provides for a fixed quantity to be delivered at a fixed price with specified timing
* A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a foreign currency
(In this case, the exchange rate is not fixed, but the foreign currency amount is.)
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment
even though future sales that will result in the royalty payments are probable.
It may, however, qualify as a forecasted transaction.)
178
Firm commitment examples:
Examples of contractual commitments satisfying the definition of a firm commitment include:
* A commodity purchase agreement that provides for a fixed quantity to be delivered at a fixed price with specified timing
* A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a foreign currency
(In this case, the exchange rate is not fixed, but the foreign currency amount is.)
• A license or royalty agreement that provides for fixed periodic payments at s___ific ti__ intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment
even though future sales that will result in the royalty payments are probable.
It may, however, qualify as a forecasted transaction.)
Firm commitment examples:
Examples of contractual commitments satisfying the definition of a firm commitment include:
* A commodity purchase agreement that provides for a fixed quantity to be delivered at a fixed price with specified timing
* A contract for the purchase of equipment on a specified delivery date at a fixed price denominated in a foreign currency
(In this case, the exchange rate is not fixed, but the foreign currency amount is.)
• A license or royalty agreement that provides for fixed periodic payments at specific time intervals
(A license or royalty agreement that specifies a unit price but does not include a minimum or fixed quantity
would not meet the definition of a firm commitment
even though future sales that will result in the royalty payments are probable.
It may, however, qualify as a forecasted transaction.)
179
Fair value hedge accounting examples
Examples of the balance sheet accounting under ASC 815 include:
• Inventory that is normally carried at the lower of cost and net realizable value* on the balance sheet when it is NOT HEDGED
will have its carrying value begin to be adjusted once it is designated as a HEDGED item in a fair value hedge.
Changes in the fair value of the inventory will begin to be reflected in income as the derivative hedging the inventory changes in value.
--------
*Inventory measured using any method other than last-in first-out (LIFO) or the retail inventory method (e.g., first-in, first-out (FIFO), average cost)
is subsequently measured at the lower of cost and net realizable value.
Inventory measured using LIFO is subsequently measured at the lower of cost or market.
Fair value hedge accounting examples
Examples of the balance sheet accounting under ASC 815 include:
• Inventory that is normally carried at the lower of cost and net realizable value* on the balance sheet when it is NOT HEDGED
will have its carrying value begin to be adjusted once it is designated as a HEDGED item in a fair value hedge.
Changes in the fair value of the inventory will begin to be reflected in income as the derivative hedging the inventory changes in value.
--------
*Inventory measured using any method other than last-in first-out (LIFO) or the retail inventory method (e.g., first-in, first-out (FIFO), average cost)
is subsequently measured at the lower of cost and net realizable value.
Inventory measured using LIFO is subsequently measured at the lower of cost or market.
180
Fair value hedge accounting examples
Examples of the balance sheet accounting under ASC 815 include:
• A firm commitment
that is prohibited by a specific accounting standard from being recognized as an asset or liability on the balance sheet (e.g., an unrecognized mortgage servicing right)
may be designated as the hedged item in a fair value hedge.
ASC 815 effectively overrides other accounting standards if the firm commitment is hedged
(or if the firm commitment meets the definition of a derivative),
because ASC 815 requires that the change in fair value of a firm commitment attributable to the risk being hedged be recognized on the balance sheet.
Fair value hedge accounting examples
Examples of the balance sheet accounting under ASC 815 include:
• A firm commitment
that is prohibited by a specific accounting standard from being recognized as an asset or liability on the balance sheet (e.g., an unrecognized mortgage servicing right)
may be designated as the hedged item in a fair value hedge.
ASC 815 effectively overrides other accounting standards if the firm commitment is hedged
(or if the firm commitment meets the definition of a derivative),
because ASC 815 requires that the change in fair value of a firm commitment attributable to the risk being hedged be recognized on the balance sheet.
181
Fair value hedge accounting examples
Examples of the balance sheet accounting under ASC 815 include:
• Available-for-sale debt securities,
if NOTE HEDGED, are carried at Fair Value,
with changes in fair value reflected on the balance sheet in AOCI (net of related taxes).
But if the available-for-sale debt security is designated as a HEDGED item in a fair value hedge,
the changes in its fair value attributable to the risk being hedged will be reflected in the income statement
— not AOCI — for as long as hedge accounting is applicable.
Fair value hedge accounting examples
Examples of the balance sheet accounting under ASC 815 include:
• Available-for-sale debt securities,
if NOTE HEDGED, are carried at Fair Value,
with changes in fair value reflected on the balance sheet in AOCI (net of related taxes).
But if the available-for-sale debt security is designated as a HEDGED item in a fair value hedge,
the changes in its fair value attributable to the risk being hedged will be reflected in the income statement
— not AOCI — for as long as hedge accounting is applicable.
182
Fair value hedge accounting examples
Examples of the balance sheet accounting under ASC 815 include:
• Held-to-maturity debt securities
are normally carried at Amortized COST on the balance sheet.
Although hedges of interest rate risk are not permitted,
a held-to-maturity debt security can be HEDGED for Credit Risk in a fair value hedge.
In these cases, the carrying value of the held-to-maturity debt security is adjusted for changes in its fair value
attributable solely to changes in the issuer’s credit risk
(e.g., credit downgrades and upgrades).
Fair value hedge accounting examples
Examples of the balance sheet accounting under ASC 815 include:
• Held-to-maturity debt securities
are normally carried at Amortized COST on the balance sheet.
Although hedges of interest rate risk are not permitted,
a held-to-maturity debt security can be HEDGED for Credit Risk in a fair value hedge.
In these cases, the carrying value of the held-to-maturity debt security is adjusted for changes in its fair value
attributable solely to changes in the issuer’s credit risk
(e.g., credit downgrades and upgrades).
183
Accounting for a fair value hedge of a firm commitment
Example:
On 1 January 20X1, a Kansas flour mill enters into a six-month forward purchase contract for
the purchase of 10,000 bushels of wheat
at $3.50/bushel (the market price on that date for forward delivery)
to be delivered on 1 July 20X1.
The wheat will be used in the mill to make flour.
Assume that the forward contract to purchase wheat represents a firm commitment that also meets the definition of a derivative.
However, the contract is not accounted for as a derivative because it meets the NPNS scope exception criteria discussed in section 2.5.2, and the flour mill has elected to apply this exception.
Accounting for a fair value hedge of a firm commitment
Example:
On 1 January 20X1, a Kansas flour mill enters into a six-month forward purchase contract for
the purchase of 10,000 bushels of wheat
at $3.50/bushel (the market price on that date for forward delivery)
to be delivered on 1 July 20X1.
The wheat will be used in the mill to make flour.
Assume that the forward contract to purchase wheat represents a firm commitment that also meets the definition of a derivative.
However, the contract is not accounted for as a derivative because it meets the NPNS scope exception criteria discussed in section 2.5.2, and the flour mill has elected to apply this exception.
184
Accounting for a fair value hedge of a firm commitment
Example: (continue 1)
On 31 March 20X1, the market price for wheat (for forward delivery in Kansas on 1 July) is $3.35.
The price has fallen based on expectations of a bumper wheat harvest.
At that time, mill management becomes concerned that the price will fall even further and that it will be forced to reduce the price of flour in response to competitive pressures.
Accordingly, it enters into a commodity swap for one-half of its commitment
whereby it will receive $3.35 on 5,000 bushels
and pay the Kansas market price on 30 June 20X1.
Accounting for a fair value hedge of a firm commitment
Example: (continue 1)
On 31 March 20X1, the market price for wheat (for forward delivery in Kansas on 1 July) is $3.35.
The price has fallen based on expectations of a bumper wheat harvest.
At that time, mill management becomes concerned that the price will fall even further and that it will be forced to reduce the price of flour in response to competitive pressures.
Accordingly, it enters into a commodity swap for one-half of its commitment
whereby it will receive $3.35 on 5,000 bushels
and pay the Kansas market price on 30 June 20X1.
185
Accounting for a fair value hedge of a firm commitment
Example: (continue 2)
On 1 July 20X1, the market price is $3.25.
Assuming there is no remaining nonperformance risk as performance is imminent,
the derivative’s fair value would represent a $500 asset
($0.10 difference between the price of wheat in the derivative contract and the current market price of wheat times 5,000 bushels).
In addition, the fair value of the firm commitment due to a change in the price of wheat has declined by the same $500.
Under ASC 815, the firm commitment would be carried as a $500 liability.
Note that the $0.15/bushel change in the fair value prior to the hedge was ignored,
as was the change in fair value of the unhedged portion of the firm commitment (the unhedged 5,000 bushels under the contract).
Only the change in price, from 31 March to 1 July 20X1, on the 5,000 hedged bushels was recognized for the firm commitment.
Accounting for a fair value hedge of a firm commitment
Example: (continue 2)
On 1 July 20X1, the market price is $3.25.
Assuming there is no remaining nonperformance risk as performance is imminent,
the derivative’s fair value would represent a $500 asset
($0.10 difference between the price of wheat in the derivative contract and the current market price of wheat times 5,000 bushels).
In addition, the fair value of the firm commitment due to a change in the price of wheat has declined by the same $500.
Under ASC 815, the firm commitment would be carried as a $500 liability.
Note that the $0.15/bushel change in the fair value prior to the hedge was ignored,
as was the change in fair value of the unhedged portion of the firm commitment (the unhedged 5,000 bushels under the contract).
Only the change in price, from 31 March to 1 July 20X1, on the 5,000 hedged bushels was recognized for the firm commitment.
186
Accounting for a fair value hedge of a firm commitment
Example:
On 1 January 20X1, a Kansas flour mill enters into a six-month forward purchase contract for
the purchase of 10,000 bushels of wheat
at $3.50/bushel (the market price on that date for forward delivery)
to be delivered on 1 July 20X1.
The wheat will be used in the mill to make flour.
Assume that the forward contract to purchase wheat represents a firm commitment that also meets the definition of a derivative.
However, the contract is not accounted for as a derivative because it meets the NPNS scope exception criteria discussed in section 2.5.2, and the flour mill has elected to apply this exception.
---------------------
Example: (continue 1)
On 31 March 20X1, the market price for wheat (for forward delivery in Kansas on 1 July) is $3.35.
The price has fallen based on expectations of a bumper wheat harvest.
At that time, mill management becomes concerned that the price will fall even further and that it will be forced to reduce the price of flour in response to competitive pressures.
Accordingly, it enters into a commodity swap for one-half of its commitment
whereby it will receive $3.35 on 5,000 bushels
and pay the Kansas market price on 30 June 20X1.
------------
Example: (continue 2)
On 1 July 20X1, the market price is $3.25.
Assuming there is no remaining nonperformance risk as performance is imminent,
the derivative’s fair value would represent a $500 asset
($0.10 difference between the price of wheat in the derivative contract and the current market price of wheat times 5,000 bushels).
In addition, the fair value of the firm commitment due to a change in the price of wheat has declined by the same $500.
Under ASC 815, the firm commitment would be carried as a $500 liability.
Note that the $0.15/bushel change in the fair value prior to the hedge was ignored,
as was the change in fair value of the unhedged portion of the firm commitment (the unhedged 5,000 bushels under the contract).
Only the change in price, from 31 March to 1 July 20X1, on the 5,000 hedged bushels was recognized for the firm commitment.
Accounting for a fair value hedge of a firm commitment
Example:
On 1 January 20X1, a Kansas flour mill enters into a six-month forward purchase contract for
the purchase of 10,000 bushels of wheat
at $3.50/bushel (the market price on that date for forward delivery)
to be delivered on 1 July 20X1.
The wheat will be used in the mill to make flour.
Assume that the forward contract to purchase wheat represents a firm commitment that also meets the definition of a derivative.
However, the contract is not accounted for as a derivative because it meets the NPNS scope exception criteria discussed in section 2.5.2, and the flour mill has elected to apply this exception.
---------------------
Example: (continue 1)
On 31 March 20X1, the market price for wheat (for forward delivery in Kansas on 1 July) is $3.35.
The price has fallen based on expectations of a bumper wheat harvest.
At that time, mill management becomes concerned that the price will fall even further and that it will be forced to reduce the price of flour in response to competitive pressures.
Accordingly, it enters into a commodity swap for one-half of its commitment
whereby it will receive $3.35 on 5,000 bushels
and pay the Kansas market price on 30 June 20X1.
------------
Example: (continue 2)
On 1 July 20X1, the market price is $3.25.
Assuming there is no remaining nonperformance risk as performance is imminent,
the derivative’s fair value would represent a $500 asset
($0.10 difference between the price of wheat in the derivative contract and the current market price of wheat times 5,000 bushels).
In addition, the fair value of the firm commitment due to a change in the price of wheat has declined by the same $500.
Under ASC 815, the firm commitment would be carried as a $500 liability.
Note that the $0.15/bushel change in the fair value prior to the hedge was ignored,
as was the change in fair value of the unhedged portion of the firm commitment (the unhedged 5,000 bushels under the contract).
Only the change in price, from 31 March to 1 July 20X1, on the 5,000 hedged bushels was recognized for the firm commitment.
187
Example 1:
Fair value hedge of a firm commitment using a forward contract
JewelryCo is a manufacturer of gold rings and necklaces.
On 1 July 20X1,
JewelryCo enters into a firm commitment to purchase 1,000 troy ounces of gold on 31 December 20X1
in New York at the current forward rate of $310/troy ounce.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and JewelryCo has elected, the NPNS scope exception in ASC 815.)
JewelryCo enters into the firm commitment because its supplier requires a fixed-price contract.
However, it would prefer to pay the market price at the time of delivery and record the gold inventory at whatever the market price will be on 31 December 20X1.
Therefore, on 1 July 20X1,
JewelryCo enters into a six-month forward contract to sell 1,000 troy ounces of gold on 31 December 20X1,
in New York at the current forward rate of $310/troy ounce.
Thus, the forward contract essentially “unlocks” the firm commitment.
The forward contract requires net cash settlement on 31 December 20X1
and has a fair value of zero at inception.
JewelryCo and the derivative counter-party are of comparable creditworthiness and the initial CVA is negligible.
JewelryCo’s formal documentation of the hedging relationship is as follows:
--------------------
Formal hedge designation documentation
• Risk management objective and nature of risk being hedged
The objective of the hedge is to protect the fair value of the firm commitment from changes in the market price of gold.
Changes in the fair value of the forward contract are expected to be highly effective in offsetting changes in the overall fair value of the entire firm commitment.
• Date of designation
1 July 20X1
• Hedging instrument
Forward contract to sell 1,000 troy ounces of gold in New York on 31 December 20X1 for $310/troy ounce
• Hedged item
Firm commitment to buy 1,000 troy ounces of gold in New York on 31 December 20X1 for $310/troy ounce. The firm commitment qualifies for the normal purchase exception.
```
• How hedge effectiveness will be assessed
Hedge effectiveness (both prospective and retrospective) will be assessed based on a comparison of the overall changes in fair value of the forward contract (i.e., based on changes in the 31 December 20X1 forward price)
and changes in the fair value of the firm commitment to purchase gold (also based on changes in the New York forward price), as expressed by a cumulative dollar-offset ratio.
The company will assess effectiveness based on changes in the forward price.
```
At inception, because the critical terms of the forward contract and firm commitment coincide (such as dates, quantities, delivery location and underlying commodity),
the company expects the hedge to be highly effective against changes in the overall fair value of the firm commitment.
However, changes in the credit risk of both counter-parties in the fair value measurement of the forward contract
and of the hedger and the supplier in the fair value measurement of the firm commitment (the hedged item)
will likely cause some mismatch (between the fair value of the forward contract and that of the firm commitment)
that needs to be considered).
The hedge meets the criteria for a fair value hedge of a firm commitment.
Example 1:
Fair value hedge of a firm commitment using a forward contract
JewelryCo is a manufacturer of gold rings and necklaces.
On 1 July 20X1,
JewelryCo enters into a firm commitment to purchase 1,000 troy ounces of gold on 31 December 20X1
in New York at the current forward rate of $310/troy ounce.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and JewelryCo has elected, the NPNS scope exception in ASC 815.)
JewelryCo enters into the firm commitment because its supplier requires a fixed-price contract.
However, it would prefer to pay the market price at the time of delivery and record the gold inventory at whatever the market price will be on 31 December 20X1.
Therefore, on 1 July 20X1,
JewelryCo enters into a six-month forward contract to sell 1,000 troy ounces of gold on 31 December 20X1,
in New York at the current forward rate of $310/troy ounce.
Thus, the forward contract essentially “unlocks” the firm commitment.
The forward contract requires net cash settlement on 31 December 20X1
and has a fair value of zero at inception.
JewelryCo and the derivative counter-party are of comparable creditworthiness and the initial CVA is negligible.
JewelryCo’s formal documentation of the hedging relationship is as follows:
--------------------
Formal hedge designation documentation
• Risk management objective and nature of risk being hedged
The objective of the hedge is to protect the fair value of the firm commitment from changes in the market price of gold.
Changes in the fair value of the forward contract are expected to be highly effective in offsetting changes in the overall fair value of the entire firm commitment.
• Date of designation
1 July 20X1
• Hedging instrument
Forward contract to sell 1,000 troy ounces of gold in New York on 31 December 20X1 for $310/troy ounce
• Hedged item
Firm commitment to buy 1,000 troy ounces of gold in New York on 31 December 20X1 for $310/troy ounce. The firm commitment qualifies for the normal purchase exception.
```
• How hedge effectiveness will be assessed
Hedge effectiveness (both prospective and retrospective) will be assessed based on a comparison of the overall changes in fair value of the forward contract (i.e., based on changes in the 31 December 20X1 forward price)
and changes in the fair value of the firm commitment to purchase gold (also based on changes in the New York forward price), as expressed by a cumulative dollar-offset ratio.
The company will assess effectiveness based on changes in the forward price.
```
At inception, because the critical terms of the forward contract and firm commitment coincide (such as dates, quantities, delivery location and underlying commodity),
the company expects the hedge to be highly effective against changes in the overall fair value of the firm commitment.
However, changes in the credit risk of both counter-parties in the fair value measurement of the forward contract
and of the hedger and the supplier in the fair value measurement of the firm commitment (the hedged item)
will likely cause some mismatch (between the fair value of the forward contract and that of the firm commitment)
that needs to be considered).
The hedge meets the criteria for a fair value hedge of a firm commitment.
188
Example 1:
Fair value hedge of a firm commitment using a forward contract
JewelryCo is a manufacturer of gold rings and necklaces. On 1 July 20X1, JewelryCo enters into a firm commitment to purchase 1,000 troy ounces of gold on 31 December 20X1 in New York at the current forward rate of $310/troy ounce.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and JewelryCo has elected, the NPNS scope exception in ASC 815.)
JewelryCo enters into the firm commitment because its supplier requires a fixed-price contract. However, it would prefer to pay the market price at the time of delivery and record the gold inventory at whatever the market price will be on 31 December 20X1.
Therefore, on 1 July 20X1, JewelryCo enters into a six-month forward contract to sell 1,000 troy ounces of gold on 31 December 20X1, in New York at the current forward rate of $310/troy ounce.
Thus, the forward contract essentially “unlocks” the firm commitment.
The forward contract requires net cash settlement on 31 December 20X1 and has a fair value of zero at inception. JewelryCo and the derivative counterparty are of comparable creditworthiness and the initial CVA is negligible.
--------------------
The following chart outlines the key assumptions by relevant date over the period of the hedge (spot prices and forward prices show cost per troy ounce of gold):
Key assumptions
Forward price Fair value of
for settlement forward
on 31 Dec 20X1 contract
(asset)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 12,708
31 Dec 20X1 285 285 25,000
-------------------
Key assumptions
Forward price Fair value of
for settlement firm
on 31 Dec 20X1 commitment
(liability)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 (12,740)
31 Dec 20X1 285 285 (25,000)
Note that the changes in fair value of the forward contract are highly effective in offsetting the assumed changes in fair value of the firm commitment
(it can be assumed that the forward price is the same for the firm commitment as it is for the forward contract).
In addition, because JewelryCo is assessing effectiveness based on changes in the forward price, the changes in the spot price are irrelevant in this example.
In this example, because the forward price has decreased, the commitment to buy gold at the higher price represents a liability.
Example 1:
Fair value hedge of a firm commitment using a forward contract
JewelryCo is a manufacturer of gold rings and necklaces. On 1 July 20X1, JewelryCo enters into a firm commitment to purchase 1,000 troy ounces of gold on 31 December 20X1 in New York at the current forward rate of $310/troy ounce.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and JewelryCo has elected, the NPNS scope exception in ASC 815.)
JewelryCo enters into the firm commitment because its supplier requires a fixed-price contract. However, it would prefer to pay the market price at the time of delivery and record the gold inventory at whatever the market price will be on 31 December 20X1.
Therefore, on 1 July 20X1, JewelryCo enters into a six-month forward contract to sell 1,000 troy ounces of gold on 31 December 20X1, in New York at the current forward rate of $310/troy ounce.
Thus, the forward contract essentially “unlocks” the firm commitment.
The forward contract requires net cash settlement on 31 December 20X1 and has a fair value of zero at inception. JewelryCo and the derivative counterparty are of comparable creditworthiness and the initial CVA is negligible.
--------------------
The following chart outlines the key assumptions by relevant date over the period of the hedge (spot prices and forward prices show cost per troy ounce of gold):
Key assumptions
Forward price Fair value of
for settlement forward
on 31 Dec 20X1 contract
(asset)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 12,708
31 Dec 20X1 285 285 25,000
-------------------
Key assumptions
Forward price Fair value of
for settlement firm
on 31 Dec 20X1 commitment
(liability)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 (12,740)
31 Dec 20X1 285 285 (25,000)
Note that the changes in fair value of the forward contract are highly effective in offsetting the assumed changes in fair value of the firm commitment
(it can be assumed that the forward price is the same for the firm commitment as it is for the forward contract).
In addition, because JewelryCo is assessing effectiveness based on changes in the forward price, the changes in the spot price are irrelevant in this example.
In this example, because the forward price has decreased, the commitment to buy gold at the higher price represents a liability.
189
Example 1:
Fair value hedge of a firm commitment using a forward contract
JewelryCo is a manufacturer of gold rings and necklaces. On 1 July 20X1, JewelryCo enters into a firm commitment to purchase 1,000 troy ounces of gold on 31 December 20X1 in New York at the current forward rate of $310/troy ounce.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and JewelryCo has elected, the NPNS scope exception in ASC 815.)
JewelryCo enters into the firm commitment because its supplier requires a fixed-price contract. However, it would prefer to pay the market price at the time of delivery and record the gold inventory at whatever the market price will be on 31 December 20X1.
Therefore, on 1 July 20X1, JewelryCo enters into a six-month forward contract to sell 1,000 troy ounces of gold on 31 December 20X1, in New York at the current forward rate of $310/troy ounce.
Thus, the forward contract essentially “unlocks” the firm commitment.
The forward contract requires net cash settlement on 31 December 20X1 and has a fair value of zero at inception. JewelryCo and the derivative counterparty are of comparable creditworthiness and the initial CVA is negligible.
------------------------
Key assumptions
Forward price Fair value of
for settlement forward
on 31 Dec 20X1 contract
(asset)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 12,708
31 Dec 20X1 285 285 25,000
-------------------
Key assumptions
Forward price Fair value of
for settlement firm
on 31 Dec 20X1 commitment
(liability)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 (12,740)
31 Dec 20X1 285 285 (25,000)
-------------------
On 1 July 20X1, no entry is required because the fair value of the forward contact is zero at hedge inception
(no premium is paid or received at inception because the terms of the forward contract are at the current forward price).
On 30 September 20X1, JewelryCo makes the following entries to record the changes in fair value of the forward contract and the firm commitment:
```
Forward contract (asset) $ 12,708
Cost of goods sold $ 12,708
```
To recognize the change in the fair value of the forward contract.
```
Cost of goods sold $ 12,740
Firm commitment (liability) $ 12,740
```
To recognize the change in the fair value of the firm commitment.
The cumulative dollar-offset ratio as of the assessment on 30 September 20X1 is: ($12,708/$12,740) = 99.7%.
This is within the 80% to 125% range considered to be “highly effective.”
On 31 December 20X1, the forward contract and the firm commitment mature.
The following journal entries are required:
Forward contract $ 12,292
Cost of goods sold $ 12,292
To recognize the change in the fair value of the forward contract.
(Calculated as $25,000 fair value of the contract at the end of the period less $12,708 fair value at the beginning of the period.)
Cost of goods sold $ 12,260
Firm commitment $ 12,260
To recognize the change in the fair value of the firm commitment.
(Calculated as $25,000 fair value of the contract at the end of the period less $12,740 fair value at the beginning of the period.)
The cumulative dollar-offset ratio as of the assessment date on 31 December 20X1 is: ($25,000/$25,000) = 100%.
The forward is perfectly effective in offsetting changes in the overall fair value of the firm commitment.
Cash $ 25,000
Forward contract $ 25,000
To record the cash settlement of the forward contract.
```
Gold inventory $ 310,000
Accounts payable (or cash) $ 310,000
```
To record the purchase of 1,000 troy ounces of gold at the $310/troy ounce contracted price.
Firm commitment $ 25,000
Gold inventory $ 25,000
To derecognize the firm commitment and adjust the carrying amount of the gold inventory.
Example 1:
Fair value hedge of a firm commitment using a forward contract
JewelryCo is a manufacturer of gold rings and necklaces. On 1 July 20X1, JewelryCo enters into a firm commitment to purchase 1,000 troy ounces of gold on 31 December 20X1 in New York at the current forward rate of $310/troy ounce.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and JewelryCo has elected, the NPNS scope exception in ASC 815.)
JewelryCo enters into the firm commitment because its supplier requires a fixed-price contract. However, it would prefer to pay the market price at the time of delivery and record the gold inventory at whatever the market price will be on 31 December 20X1.
Therefore, on 1 July 20X1, JewelryCo enters into a six-month forward contract to sell 1,000 troy ounces of gold on 31 December 20X1, in New York at the current forward rate of $310/troy ounce.
Thus, the forward contract essentially “unlocks” the firm commitment.
The forward contract requires net cash settlement on 31 December 20X1 and has a fair value of zero at inception. JewelryCo and the derivative counterparty are of comparable creditworthiness and the initial CVA is negligible.
------------------------
Key assumptions
Forward price Fair value of
for settlement forward
on 31 Dec 20X1 contract
(asset)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 12,708
31 Dec 20X1 285 285 25,000
-------------------
Key assumptions
Forward price Fair value of
for settlement firm
on 31 Dec 20X1 commitment
(liability)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 (12,740)
31 Dec 20X1 285 285 (25,000)
-------------------
On 1 July 20X1, no entry is required because the fair value of the forward contact is zero at hedge inception
(no premium is paid or received at inception because the terms of the forward contract are at the current forward price).
On 30 September 20X1, JewelryCo makes the following entries to record the changes in fair value of the forward contract and the firm commitment:
```
Forward contract (asset) $ 12,708
Cost of goods sold $ 12,708
```
To recognize the change in the fair value of the forward contract.
```
Cost of goods sold $ 12,740
Firm commitment (liability) $ 12,740
```
To recognize the change in the fair value of the firm commitment.
The cumulative dollar-offset ratio as of the assessment on 30 September 20X1 is: ($12,708/$12,740) = 99.7%.
This is within the 80% to 125% range considered to be “highly effective.”
On 31 December 20X1, the forward contract and the firm commitment mature.
The following journal entries are required:
Forward contract $ 12,292
Cost of goods sold $ 12,292
To recognize the change in the fair value of the forward contract.
(Calculated as $25,000 fair value of the contract at the end of the period less $12,708 fair value at the beginning of the period.)
Cost of goods sold $ 12,260
Firm commitment $ 12,260
To recognize the change in the fair value of the firm commitment.
(Calculated as $25,000 fair value of the contract at the end of the period less $12,740 fair value at the beginning of the period.)
The cumulative dollar-offset ratio as of the assessment date on 31 December 20X1 is: ($25,000/$25,000) = 100%.
The forward is perfectly effective in offsetting changes in the overall fair value of the firm commitment.
Cash $ 25,000
Forward contract $ 25,000
To record the cash settlement of the forward contract.
```
Gold inventory $ 310,000
Accounts payable (or cash) $ 310,000
```
To record the purchase of 1,000 troy ounces of gold at the $310/troy ounce contracted price.
Firm commitment $ 25,000
Gold inventory $ 25,000
To derecognize the firm commitment and adjust the carrying amount of the gold inventory.
190
Example 1:
Fair value hedge of a firm commitment using a forward contract
------------------------
Key assumptions
Forward price Fair value of
for settlement forward
on 31 Dec 20X1 contract
(asset)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 12,708*
31 Dec 20X1 285 285 25,000
-------------------
Key assumptions
Forward price Fair value of
for settlement firm
on 31 Dec 20X1 commitment
(liability)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 (12,740)
31 Dec 20X1 285 285 (25,000)
-------------------
* The fair value of the forward contract can be estimated by
(1) multiplying the change in the forward price since inception of the contract by the notional amount of the contract and
(2) discounting that amount at an appropriate rate for the remaining term of the forward.
At 30 September 20X1, the calculation is as follows: $12,808 = ($310 – $297) x 1,000 ounces of gold,
discounted at 6%
(assumed to be an appropriate rate) for three months.
Because the forward price has decreased, the value of the derivative has increased and, therefore, represents an asset.
In addition, the company determined that a CVA of ($100) should be included in the fair value measurement of the forward contract, resulting in a fair value of $12,708 as of 30 September 20X1.
Example 1:
Fair value hedge of a firm commitment using a forward contract
------------------------
Key assumptions
Forward price Fair value of
for settlement forward
on 31 Dec 20X1 contract
(asset)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 12,708*
31 Dec 20X1 285 285 25,000
-------------------
Key assumptions
Forward price Fair value of
for settlement firm
on 31 Dec 20X1 commitment
(liability)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 (12,740)
31 Dec 20X1 285 285 (25,000)
-------------------
* The fair value of the forward contract can be estimated by
(1) multiplying the change in the forward price since inception of the contract by the notional amount of the contract and
(2) discounting that amount at an appropriate rate for the remaining term of the forward.
At 30 September 20X1, the calculation is as follows: $12,808 = ($310 – $297) x 1,000 ounces of gold,
discounted at 6%
(assumed to be an appropriate rate) for three months.
Because the forward price has decreased, the value of the derivative has increased and, therefore, represents an asset.
In addition, the company determined that a CVA of ($100) should be included in the fair value measurement of the forward contract, resulting in a fair value of $12,708 as of 30 September 20X1.
191
Example 1:
Fair value hedge of a firm commitment using a forward contract
------------------------
Key assumptions
Forward price Fair value of
for settlement forward
on 31 Dec 20X1 contract
(asset)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 12,708
31 Dec 20X1 285 285 25,000
-------------------
Key assumptions
Forward price Fair value of
for settlement firm
on 31 Dec 20X1 commitment
(liability)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 (12,740)*
31 Dec 20X1 285 285 (25,000)
-------------------
*The fair value of the firm commitment before consideration of the company’s own nonperformance risk is ($12,808).
A reduction of ($68) to the fair value of the liability reflects an increase in the company’s own nonperformance risk.
Example 1:
Fair value hedge of a firm commitment using a forward contract
------------------------
Key assumptions
Forward price Fair value of
for settlement forward
on 31 Dec 20X1 contract
(asset)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 12,708
31 Dec 20X1 285 285 25,000
-------------------
Key assumptions
Forward price Fair value of
for settlement firm
on 31 Dec 20X1 commitment
(liability)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 (12,740)*
31 Dec 20X1 285 285 (25,000)
-------------------
*The fair value of the firm commitment before consideration of the company’s own nonperformance risk is ($12,808).
A reduction of ($68) to the fair value of the liability reflects an increase in the company’s own nonperformance risk.
192
Example 1:
Fair value hedge of a firm commitment using a forward contract
------------------------
Key assumptions
Forward price Fair value of
for settlement forward
on 31 Dec 20X1 contract
(asset)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 12,708
31 Dec 20X1 285 285 25,000*
-------------------
Key assumptions
Forward price Fair value of
for settlement firm
on 31 Dec 20X1 commitment
(liability)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 (12,740)
31 Dec 20X1 285 285 (25,000)
-------------------
*Calculation at 31 December 20X1: $25,000 = ($310 — $285) x 1,000.
(No discounting is required on 31 December 20X1 because the forward contract is at maturity.)
Example 1:
Fair value hedge of a firm commitment using a forward contract
------------------------
Key assumptions
Forward price Fair value of
for settlement forward
on 31 Dec 20X1 contract
(asset)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 12,708
31 Dec 20X1 285 285 25,000*
-------------------
Key assumptions
Forward price Fair value of
for settlement firm
on 31 Dec 20X1 commitment
(liability)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 (12,740)
31 Dec 20X1 285 285 (25,000)
-------------------
*Calculation at 31 December 20X1: $25,000 = ($310 — $285) x 1,000.
(No discounting is required on 31 December 20X1 because the forward contract is at maturity.)
193
Example 1:
Fair value hedge of a firm commitment using a forward contract
JewelryCo is a manufacturer of gold rings and necklaces. On 1 July 20X1, JewelryCo enters into a firm commitment to purchase 1,000 troy ounces of gold on 31 December 20X1 in New York at the current forward rate of $310/troy ounce.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and JewelryCo has elected, the NPNS scope exception in ASC 815.)
JewelryCo enters into the firm commitment because its supplier requires a fixed-price contract. However, it would prefer to pay the market price at the time of delivery and record the gold inventory at whatever the market price will be on 31 December 20X1.
Therefore, on 1 July 20X1, JewelryCo enters into a six-month forward contract to sell 1,000 troy ounces of gold on 31 December 20X1, in New York at the current forward rate of $310/troy ounce.
Thus, the forward contract essentially “unlocks” the firm commitment.
The forward contract requires net cash settlement on 31 December 20X1 and has a fair value of zero at inception. JewelryCo and the derivative counterparty are of comparable creditworthiness and the initial CVA is negligible.
--------------------
The following chart outlines the key assumptions by relevant date over the period of the hedge (spot prices and forward prices show cost per troy ounce of gold):
Key assumptions
Forward price Fair value of
for settlement forward
on 31 Dec 20X1 contract
(asset)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 12,708
31 Dec 20X1 285 285 25,000
-------------------
Key assumptions
Forward price Fair value of
for settlement firm
on 31 Dec 20X1 commitment
(liability)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 (12,740)
31 Dec 20X1 285 285 (25,000)
----------------------------------------
Effect of the hedge on the income statement
In this example, the loss on the firm commitment was offset by the gain on the forward contract.
While there were differences in changes in the credit valuation adjustment on the forward contract and on the hedged firm commitment during the life of the hedge,
those differences netted to zero by the final day of the hedge.
However, the differences between the hedged firm commitment and the hedging instrument result in some volatility to cost of goods sold in each period (prior to the sale of the gold)
because the entire change in fair value of the forward contract and the firm commitment is required to be recorded in that income statement line.
Over the life of the hedging relationship, the total net effect on net income is zero.
However, as a result of the hedge, the gold inventory is initially reported at $285,000 rather than $310,000.
The $285,000 is composed of the $310,000 paid to the gold supplier less the $25,000 gain from the hedge.
It reflects the spot rate in effect on 31 December 20X1, and is consistent with JewelryCo’s strategy to effectively acquire the inventory at the market price on the date of delivery from the supplier.
JewelryCo will benefit from the hedge in future periods through a lower cost of goods sold as the inventory is used in its production cycle and its finished product (jewelry) is sold.
Example 1:
Fair value hedge of a firm commitment using a forward contract
JewelryCo is a manufacturer of gold rings and necklaces. On 1 July 20X1, JewelryCo enters into a firm commitment to purchase 1,000 troy ounces of gold on 31 December 20X1 in New York at the current forward rate of $310/troy ounce.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and JewelryCo has elected, the NPNS scope exception in ASC 815.)
JewelryCo enters into the firm commitment because its supplier requires a fixed-price contract. However, it would prefer to pay the market price at the time of delivery and record the gold inventory at whatever the market price will be on 31 December 20X1.
Therefore, on 1 July 20X1, JewelryCo enters into a six-month forward contract to sell 1,000 troy ounces of gold on 31 December 20X1, in New York at the current forward rate of $310/troy ounce.
Thus, the forward contract essentially “unlocks” the firm commitment.
The forward contract requires net cash settlement on 31 December 20X1 and has a fair value of zero at inception. JewelryCo and the derivative counterparty are of comparable creditworthiness and the initial CVA is negligible.
--------------------
The following chart outlines the key assumptions by relevant date over the period of the hedge (spot prices and forward prices show cost per troy ounce of gold):
Key assumptions
Forward price Fair value of
for settlement forward
on 31 Dec 20X1 contract
(asset)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 12,708
31 Dec 20X1 285 285 25,000
-------------------
Key assumptions
Forward price Fair value of
for settlement firm
on 31 Dec 20X1 commitment
(liability)
Date Spot price
1 Jul 20X1 $ 300 $ 310 $ —
30 Sep 20X1 292 297 (12,740)
31 Dec 20X1 285 285 (25,000)
----------------------------------------
Effect of the hedge on the income statement
In this example, the loss on the firm commitment was offset by the gain on the forward contract.
While there were differences in changes in the credit valuation adjustment on the forward contract and on the hedged firm commitment during the life of the hedge,
those differences netted to zero by the final day of the hedge.
However, the differences between the hedged firm commitment and the hedging instrument result in some volatility to cost of goods sold in each period (prior to the sale of the gold)
because the entire change in fair value of the forward contract and the firm commitment is required to be recorded in that income statement line.
Over the life of the hedging relationship, the total net effect on net income is zero.
However, as a result of the hedge, the gold inventory is initially reported at $285,000 rather than $310,000.
The $285,000 is composed of the $310,000 paid to the gold supplier less the $25,000 gain from the hedge.
It reflects the spot rate in effect on 31 December 20X1, and is consistent with JewelryCo’s strategy to effectively acquire the inventory at the market price on the date of delivery from the supplier.
JewelryCo will benefit from the hedge in future periods through a lower cost of goods sold as the inventory is used in its production cycle and its finished product (jewelry) is sold.
194
Example 2:
Fair value hedge of a firm commitment using a futures contract
On 1 January 20X1, a gold mining operation enters into a fixed-price contract
to deliver 100 troy ounces of gold on 30 June 20X1 to a customer in London at a price of $310/troy ounce,
the forward price of gold on 1 January 20X1 for delivery in London on 30 June 20X1.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and the company has elected, the NPNS scope exception in ASC 815.)
The company would have preferred for the sales contract to have been at the market price on the date of delivery,
but as a concession to its customer offered it a fixed-price contract.
To hedge against the potential opportunity loss in revenue due to an increase in gold prices,
on 1 January 20X1,
the company enters into a New York Mercantile Exchange (NYMEX) futures contract
to purchase 100 troy ounces at a price of $300/troy ounce for delivery in June.
The NYMEX contract requires delivery in New York.
Example 2:
Fair value hedge of a firm commitment using a futures contract
On 1 January 20X1, a gold mining operation enters into a fixed-price contract
to deliver 100 troy ounces of gold on 30 June 20X1 to a customer in London at a price of $310/troy ounce,
the forward price of gold on 1 January 20X1 for delivery in London on 30 June 20X1.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and the company has elected, the NPNS scope exception in ASC 815.)
The company would have preferred for the sales contract to have been at the market price on the date of delivery,
but as a concession to its customer offered it a fixed-price contract.
To hedge against the potential opportunity loss in revenue due to an increase in gold prices,
on 1 January 20X1,
the company enters into a New York Mercantile Exchange (NYMEX) futures contract
to purchase 100 troy ounces at a price of $300/troy ounce for delivery in June.
The NYMEX contract requires delivery in New York.
195
Example 2:
Fair value hedge of a firm commitment using a futures contract
On 1 January 20X1, a gold mining operation enters into a fixed-price contract
to deliver 100 troy ounces of gold on 30 June 20X1 to a customer in London at a price of $310/troy ounce,
the forward price of gold on 1 January 20X1 for delivery in London on 30 June 20X1.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and the company has elected, the NPNS scope exception in ASC 815.)
The company would have preferred for the sales contract to have been at the market price on the date of delivery,
but as a concession to its customer offered it a fixed-price contract.
To hedge against the potential opportunity loss in revenue due to an increase in gold prices,
on 1 January 20X1,
the company enters into a New York Mercantile Exchange (NYMEX) futures contract
to purchase 100 troy ounces at a price of $300/troy ounce for delivery in June.
The NYMEX contract requires delivery in New York.
-----------------
The company’s strategy is that,
because it is concerned that prices will go up between now and delivery in June,
the “long” futures contract (contract to buy) effectively eliminates the risk
of being committed to a sales price over the next six months at the 1 January price.
If prices do go up over the next six months, the fair value of the firm sales commitment will decline
because it will be at a below-market price,
but the company will benefit from the hedge as the fair value of the futures contract increases.
Example 2:
Fair value hedge of a firm commitment using a futures contract
On 1 January 20X1, a gold mining operation enters into a fixed-price contract
to deliver 100 troy ounces of gold on 30 June 20X1 to a customer in London at a price of $310/troy ounce,
the forward price of gold on 1 January 20X1 for delivery in London on 30 June 20X1.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and the company has elected, the NPNS scope exception in ASC 815.)
The company would have preferred for the sales contract to have been at the market price on the date of delivery,
but as a concession to its customer offered it a fixed-price contract.
To hedge against the potential opportunity loss in revenue due to an increase in gold prices,
on 1 January 20X1,
the company enters into a New York Mercantile Exchange (NYMEX) futures contract
to purchase 100 troy ounces at a price of $300/troy ounce for delivery in June.
The NYMEX contract requires delivery in New York.
-----------------
The company’s strategy is that,
because it is concerned that prices will go up between now and delivery in June,
the “long” futures contract (contract to buy) effectively eliminates the risk
of being committed to a sales price over the next six months at the 1 January price.
If prices do go up over the next six months, the fair value of the firm sales commitment will decline
because it will be at a below-market price,
but the company will benefit from the hedge as the fair value of the futures contract increases.
196
Example 2:
Fair value hedge of a firm commitment using a futures contract
On 1 January 20X1, a gold mining operation enters into a fixed-price contract
to deliver 100 troy ounces of gold on 30 June 20X1 to a customer in London at a price of $310/troy ounce,
the forward price of gold on 1 January 20X1 for delivery in London on 30 June 20X1.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and the company has elected, the NPNS scope exception in ASC 815.)
The company would have preferred for the sales contract to have been at the market price on the date of delivery,
but as a concession to its customer offered it a fixed-price contract.
To hedge against the potential opportunity loss in revenue due to an increase in gold prices,
on 1 January 20X1,
the company enters into a New York Mercantile Exchange (NYMEX) futures contract
to purchase 100 troy ounces at a price of $300/troy ounce for delivery in June.
The NYMEX contract requires delivery in New York.
-----------------
The company’s strategy is that,
because it is concerned that prices will go up between now and delivery in June,
the “long” futures contract (contract to buy) effectively eliminates the risk
of being committed to a sales price over the next six months at the 1 January price.
If prices do go up over the next six months, the fair value of the firm sales commitment will decline
because it will be at a below-market price,
but the company will benefit from the hedge as the fair value of the futures contract increases.
-----
If prices decline,
the company will benefit from an increase in value of its firm commitment
but experience a loss from the hedge.
The company is accepting some “basis” risk in that it is assuming that the NYMEX price will fluctuate consistently with the London price over the next six months.
To the extent that the two markets do not fluctuate consistently,
a mismatch will result in earnings.
However, the company must have the expectation that market movements in the two locations will be correlated enough
that the futures contract will be highly effective as a hedge.
Example 2:
Fair value hedge of a firm commitment using a futures contract
On 1 January 20X1, a gold mining operation enters into a fixed-price contract
to deliver 100 troy ounces of gold on 30 June 20X1 to a customer in London at a price of $310/troy ounce,
the forward price of gold on 1 January 20X1 for delivery in London on 30 June 20X1.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and the company has elected, the NPNS scope exception in ASC 815.)
The company would have preferred for the sales contract to have been at the market price on the date of delivery,
but as a concession to its customer offered it a fixed-price contract.
To hedge against the potential opportunity loss in revenue due to an increase in gold prices,
on 1 January 20X1,
the company enters into a New York Mercantile Exchange (NYMEX) futures contract
to purchase 100 troy ounces at a price of $300/troy ounce for delivery in June.
The NYMEX contract requires delivery in New York.
-----------------
The company’s strategy is that,
because it is concerned that prices will go up between now and delivery in June,
the “long” futures contract (contract to buy) effectively eliminates the risk
of being committed to a sales price over the next six months at the 1 January price.
If prices do go up over the next six months, the fair value of the firm sales commitment will decline
because it will be at a below-market price,
but the company will benefit from the hedge as the fair value of the futures contract increases.
-----
If prices decline,
the company will benefit from an increase in value of its firm commitment
but experience a loss from the hedge.
The company is accepting some “basis” risk in that it is assuming that the NYMEX price will fluctuate consistently with the London price over the next six months.
To the extent that the two markets do not fluctuate consistently,
a mismatch will result in earnings.
However, the company must have the expectation that market movements in the two locations will be correlated enough
that the futures contract will be highly effective as a hedge.
197
Example 2:
Fair value hedge of a firm commitment using a futures contract
On 1 January 20X1, a gold mining operation enters into a fixed-price contract
to deliver 100 troy ounces of gold on 30 June 20X1 to a customer in London at a price of $310/troy ounce,
the forward price of gold on 1 January 20X1 for delivery in London on 30 June 20X1.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and the company has elected, the NPNS scope exception in ASC 815.)
The company would have preferred for the sales contract to have been at the market price on the date of delivery,
but as a concession to its customer offered it a fixed-price contract.
To hedge against the potential opportunity loss in revenue due to an increase in gold prices,
on 1 January 20X1,
the company enters into a New York Mercantile Exchange (NYMEX) futures contract
to purchase 100 troy ounces at a price of $300/troy ounce for delivery in June.
The NYMEX contract requires delivery in New York.
-----------------
The company’s designation is as follows:
Formal hedge designation documentation
• Risk management objective and nature of risk being hedged
The objective of the hedge is to protect the fair value of the firm commitment from changes in the market price of gold.
Changes in the fair value of the NYMEX gold futures contract are expected to be highly effective in offsetting changes in the fair value of the entire firm commitment contract caused by changes in the London gold price.
• Date of designation
1 January 20X1
• Hedging instrument
NYMEX long futures contract for 100 troy ounces of gold in New York at a price of $300/troy ounce on 30 June 20X1.
• Hedged item
Firm commitment to deliver 100 troy ounces of gold in London at a price of $310/troy ounce on 30 June 20X1.
The firm commitment qualifies for the normal sales exception.
```
• How hedge effectiveness will be assessed
Hedge effectiveness (both prospective and retrospective) will be assessed based on a cumulative dollar-offset ratio
```
comparison of the overall changes in fair value of the futures contract traded on NYMEX
and changes in the fair value of the gold based on changes in the London forward price.
The use of a six-month NYMEX futures contract to hedge against changes in the London forward price would have been highly effective over the last six months of 20X0
as the London forward price has increased $50,
while the NYMEX futures price increased $49.
The hedge meets the criteria for a fair value hedge of a firm commitment.
Example 2:
Fair value hedge of a firm commitment using a futures contract
On 1 January 20X1, a gold mining operation enters into a fixed-price contract
to deliver 100 troy ounces of gold on 30 June 20X1 to a customer in London at a price of $310/troy ounce,
the forward price of gold on 1 January 20X1 for delivery in London on 30 June 20X1.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and the company has elected, the NPNS scope exception in ASC 815.)
The company would have preferred for the sales contract to have been at the market price on the date of delivery,
but as a concession to its customer offered it a fixed-price contract.
To hedge against the potential opportunity loss in revenue due to an increase in gold prices,
on 1 January 20X1,
the company enters into a New York Mercantile Exchange (NYMEX) futures contract
to purchase 100 troy ounces at a price of $300/troy ounce for delivery in June.
The NYMEX contract requires delivery in New York.
-----------------
The company’s designation is as follows:
Formal hedge designation documentation
• Risk management objective and nature of risk being hedged
The objective of the hedge is to protect the fair value of the firm commitment from changes in the market price of gold.
Changes in the fair value of the NYMEX gold futures contract are expected to be highly effective in offsetting changes in the fair value of the entire firm commitment contract caused by changes in the London gold price.
• Date of designation
1 January 20X1
• Hedging instrument
NYMEX long futures contract for 100 troy ounces of gold in New York at a price of $300/troy ounce on 30 June 20X1.
• Hedged item
Firm commitment to deliver 100 troy ounces of gold in London at a price of $310/troy ounce on 30 June 20X1.
The firm commitment qualifies for the normal sales exception.
```
• How hedge effectiveness will be assessed
Hedge effectiveness (both prospective and retrospective) will be assessed based on a cumulative dollar-offset ratio
```
comparison of the overall changes in fair value of the futures contract traded on NYMEX
and changes in the fair value of the gold based on changes in the London forward price.
The use of a six-month NYMEX futures contract to hedge against changes in the London forward price would have been highly effective over the last six months of 20X0
as the London forward price has increased $50,
while the NYMEX futures price increased $49.
The hedge meets the criteria for a fair value hedge of a firm commitment.
198
Example 2:
Fair value hedge of a firm commitment using a futures contract
On 1 January 20X1, a gold mining operation enters into a fixed-price contract
to deliver 100 troy ounces of gold on 30 June 20X1 to a customer in London at a price of $310/troy ounce,
the forward price of gold on 1 January 20X1 for delivery in London on 30 June 20X1.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and the company has elected, the NPNS scope exception in ASC 815.)
The company would have preferred for the sales contract to have been at the market price on the date of delivery,
but as a concession to its customer offered it a fixed-price contract.
To hedge against the potential opportunity loss in revenue due to an increase in gold prices,
on 1 January 20X1,
the company enters into a New York Mercantile Exchange (NYMEX) futures contract
to purchase 100 troy ounces at a price of $300/troy ounce for delivery in June.
The NYMEX contract requires delivery in New York.
-----------------
At 31 March 20X1,
the London forward price for delivery on 30 June 20X1 is $350
and the June NYMEX futures price is $345.
The fair value of the futures contract is $4,500*
($45 increase in NYMEX futures price times 100 troy ounces).
However, the firm commitment has decreased in value because the London forward price has risen $40/troy ounce.
---------
*Futures are exchange-traded derivatives,
meaning that the exchanges act as the counter-party on all contracts,
effectively dispersing the exchange’s nonperformance risk among the entire membership of the exchange.
Additionally, futures are margined daily
in that settlement reflecting the change in fair value of the derivative contract takes place daily.
Although credit risk may not be eliminated completely, credit exposure associated with both parties to a futures contract is minimal.
Accordingly, no CVA is factored into the fair value of futures contracts in this example.
For purposes of this example, nonperformance risk associated with the firm commitment is also assumed to be nil and has therefore been ignored.
Example 2:
Fair value hedge of a firm commitment using a futures contract
On 1 January 20X1, a gold mining operation enters into a fixed-price contract
to deliver 100 troy ounces of gold on 30 June 20X1 to a customer in London at a price of $310/troy ounce,
the forward price of gold on 1 January 20X1 for delivery in London on 30 June 20X1.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and the company has elected, the NPNS scope exception in ASC 815.)
The company would have preferred for the sales contract to have been at the market price on the date of delivery,
but as a concession to its customer offered it a fixed-price contract.
To hedge against the potential opportunity loss in revenue due to an increase in gold prices,
on 1 January 20X1,
the company enters into a New York Mercantile Exchange (NYMEX) futures contract
to purchase 100 troy ounces at a price of $300/troy ounce for delivery in June.
The NYMEX contract requires delivery in New York.
-----------------
At 31 March 20X1,
the London forward price for delivery on 30 June 20X1 is $350
and the June NYMEX futures price is $345.
The fair value of the futures contract is $4,500*
($45 increase in NYMEX futures price times 100 troy ounces).
However, the firm commitment has decreased in value because the London forward price has risen $40/troy ounce.
---------
*Futures are exchange-traded derivatives,
meaning that the exchanges act as the counter-party on all contracts,
effectively dispersing the exchange’s nonperformance risk among the entire membership of the exchange.
Additionally, futures are margined daily
in that settlement reflecting the change in fair value of the derivative contract takes place daily.
Although credit risk may not be eliminated completely, credit exposure associated with both parties to a futures contract is minimal.
Accordingly, no CVA is factored into the fair value of futures contracts in this example.
For purposes of this example, nonperformance risk associated with the firm commitment is also assumed to be nil and has therefore been ignored.
199
Example 2:
Fair value hedge of a firm commitment using a futures contract
On 1 January 20X1, a gold mining operation enters into a fixed-price contract
to deliver 100 troy ounces of gold on 30 June 20X1 to a customer in London at a price of $310/troy ounce,
the forward price of gold on 1 January 20X1 for delivery in London on 30 June 20X1.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and the company has elected, the NPNS scope exception in ASC 815.)
The company would have preferred for the sales contract to have been at the market price on the date of delivery,
but as a concession to its customer offered it a fixed-price contract.
To hedge against the potential opportunity loss in revenue due to an increase in gold prices,
on 1 January 20X1,
the company enters into a New York Mercantile Exchange (NYMEX) futures contract
to purchase 100 troy ounces at a price of $300/troy ounce for delivery in June.
The NYMEX contract requires delivery in New York.
-----------------
The company’s strategy is that,
because it is concerned that prices will go up between now and delivery in June,
the “long” futures contract (contract to buy) effectively eliminates the risk
of being committed to a sales price over the next six months at the 1 January price.
If prices do go up over the next six months, the fair value of the firm sales commitment will decline
because it will be at a below-market price,
but the company will benefit from the hedge as the fair value of the futures contract increases.
-----
If prices decline,
the company will benefit from an increase in value of its firm commitment
but experience a loss from the hedge.
The company is accepting some “basis” risk in that it is assuming that the NYMEX price will fluctuate consistently with the London price over the next six months*.
To the extent that the two markets do not fluctuate consistently,
a mismatch will result in earnings.
However, the company must have the expectation that market movements in the two locations will be correlated enough
that the futures contract will be highly effective as a hedge.
----------------
```
* “Basis risk”
is the risk that a price difference is created because of differences in
- a commodity delivery location,
- quality or grade of commodity, or
- other commodity-specific variable.
```
For example,
an entity stores natural gas in Houston, Texas, but it hedges its inventory using natural gas futures contracts based on delivery of natural gas at the Henry Hub gas collection point in Louisiana.
Thus to the extent there is a difference in price of natural gas in Houston
and that underlying the Henry Hub-based futures contract,
the difference relates to location differences,
such as transportation costs and supply and demand at the different locations.
Interest rate instruments can also have basis differences
(e.g., different variable-rate indexes, different credit risk, different terms).
Example 2:
Fair value hedge of a firm commitment using a futures contract
On 1 January 20X1, a gold mining operation enters into a fixed-price contract
to deliver 100 troy ounces of gold on 30 June 20X1 to a customer in London at a price of $310/troy ounce,
the forward price of gold on 1 January 20X1 for delivery in London on 30 June 20X1.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and the company has elected, the NPNS scope exception in ASC 815.)
The company would have preferred for the sales contract to have been at the market price on the date of delivery,
but as a concession to its customer offered it a fixed-price contract.
To hedge against the potential opportunity loss in revenue due to an increase in gold prices,
on 1 January 20X1,
the company enters into a New York Mercantile Exchange (NYMEX) futures contract
to purchase 100 troy ounces at a price of $300/troy ounce for delivery in June.
The NYMEX contract requires delivery in New York.
-----------------
The company’s strategy is that,
because it is concerned that prices will go up between now and delivery in June,
the “long” futures contract (contract to buy) effectively eliminates the risk
of being committed to a sales price over the next six months at the 1 January price.
If prices do go up over the next six months, the fair value of the firm sales commitment will decline
because it will be at a below-market price,
but the company will benefit from the hedge as the fair value of the futures contract increases.
-----
If prices decline,
the company will benefit from an increase in value of its firm commitment
but experience a loss from the hedge.
The company is accepting some “basis” risk in that it is assuming that the NYMEX price will fluctuate consistently with the London price over the next six months*.
To the extent that the two markets do not fluctuate consistently,
a mismatch will result in earnings.
However, the company must have the expectation that market movements in the two locations will be correlated enough
that the futures contract will be highly effective as a hedge.
----------------
```
* “Basis risk”
is the risk that a price difference is created because of differences in
- a commodity delivery location,
- quality or grade of commodity, or
- other commodity-specific variable.
```
For example,
an entity stores natural gas in Houston, Texas, but it hedges its inventory using natural gas futures contracts based on delivery of natural gas at the Henry Hub gas collection point in Louisiana.
Thus to the extent there is a difference in price of natural gas in Houston
and that underlying the Henry Hub-based futures contract,
the difference relates to location differences,
such as transportation costs and supply and demand at the different locations.
Interest rate instruments can also have basis differences
(e.g., different variable-rate indexes, different credit risk, different terms).
200
Example 2:
Fair value hedge of a firm commitment using a futures contract
The company’s designation is as follows:
Formal hedge designation documentation
```
• How hedge effectiveness will be assessed
Hedge effectiveness (both prospective and retrospective) will be assessed based on a cumulative dollar-offset ratio
```
comparison of the overall changes in fair value of the futures contract traded on NYMEX
and changes in the fair value of the gold based on changes in the London forward price.
The use of a six-month NYMEX futures contract to hedge against changes in the London forward price would have been highly effective over the last six months of 20X0
as the London forward price has increased $50,
while the NYMEX futures price increased $49*.
The hedge meets the criteria for a fair value hedge of a firm commitment.
---------------
*As a practical matter, for non-perfect hedges,
entities should justify why they expect the derivative to be highly effective
based on prior history
as well as how they will assess effectiveness in the future.
Example 2:
Fair value hedge of a firm commitment using a futures contract
The company’s designation is as follows:
Formal hedge designation documentation
```
• How hedge effectiveness will be assessed
Hedge effectiveness (both prospective and retrospective) will be assessed based on a cumulative dollar-offset ratio
```
comparison of the overall changes in fair value of the futures contract traded on NYMEX
and changes in the fair value of the gold based on changes in the London forward price.
The use of a six-month NYMEX futures contract to hedge against changes in the London forward price would have been highly effective over the last six months of 20X0
as the London forward price has increased $50,
while the NYMEX futures price increased $49*.
The hedge meets the criteria for a fair value hedge of a firm commitment.
---------------
*As a practical matter, for non-perfect hedges,
entities should justify why they expect the derivative to be highly effective
based on prior history
as well as how they will assess effectiveness in the future.
201
Example 2:
Fair value hedge of a firm commitment using a futures contract
At 31 March 20X1,
the London forward price for delivery on 30 June 20X1 is $350
and the June NYMEX futures price is $345.
The fair value of the futures contract is $4,500*
($45 increase in NYMEX futures price times 100 troy ounces).
However, the firm commitment has decreased in value because the London forward price has risen $40/troy ounce.
-------------
*Futures are exchange-traded derivatives,
meaning that the exchanges act as the counter-party on all contracts,
effectively dispersing the exchange’s nonperformance risk among the entire membership of the exchange.
Additionally, futures are margined daily in that settlement reflecting the change in fair value of the derivative contract takes place daily.
Although credit risk may not be eliminated completely, credit exposure associated with both parties to a futures contract is minimal.
Accordingly, no CVA is factored into the fair value of futures contracts in this example.
For purposes of this example, nonperformance risk associated with the firm commitment is also assumed to be nil and has therefore been ignored.
Example 2:
Fair value hedge of a firm commitment using a futures contract
At 31 March 20X1,
the London forward price for delivery on 30 June 20X1 is $350
and the June NYMEX futures price is $345.
The fair value of the futures contract is $4,500*
($45 increase in NYMEX futures price times 100 troy ounces).
However, the firm commitment has decreased in value because the London forward price has risen $40/troy ounce.
-------------
*Futures are exchange-traded derivatives,
meaning that the exchanges act as the counter-party on all contracts,
effectively dispersing the exchange’s nonperformance risk among the entire membership of the exchange.
Additionally, futures are margined daily in that settlement reflecting the change in fair value of the derivative contract takes place daily.
Although credit risk may not be eliminated completely, credit exposure associated with both parties to a futures contract is minimal.
Accordingly, no CVA is factored into the fair value of futures contracts in this example.
For purposes of this example, nonperformance risk associated with the firm commitment is also assumed to be nil and has therefore been ignored.
202
Example 2:
Fair value hedge of a firm commitment using a futures contract
On 1 January 20X1, a gold mining operation enters into a fixed-price contract
to deliver 100 troy ounces of gold on 30 June 20X1 to a customer in London at a price of $310/troy ounce,
the forward price of gold on 1 January 20X1 for delivery in London on 30 June 20X1.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and the company has elected, the NPNS scope exception in ASC 815.)
The company would have preferred for the sales contract to have been at the market price on the date of delivery,
but as a concession to its customer offered it a fixed-price contract.
To hedge against the potential opportunity loss in revenue due to an increase in gold prices,
on 1 January 20X1,
the company enters into a New York Mercantile Exchange (NYMEX) futures contract
to purchase 100 troy ounces at a price of $300/troy ounce for delivery in June.
The NYMEX contract requires delivery in New York.
--------------------
Through the first quarter of 20X1,
the company would have made entries (ignoring margin requirements) totaling the following:
New York gold futures contract $ 4,500
Sales $ 4,500
To recognize change in the fair value of futures contract.
```
Sales $ 4,000
Firm commitment (liability) $ 4,000
```
To recognize the change in the fair value of the firm contract to sell gold at a price of $310 when the current forward price is $350/troy ounce.
The net effect of the above entries is an increase in income of $500
due to differences in the changes in fair value of the firm commitment vs. the changes in fair value of the NYMEX futures contract.
This difference can be calculated as follows:
Change in New York futures price ($345 — $300) $ 45
Change in London forward price ($350 — $310) 40
Difference $ 5
x 100 ounces
Net effect on earnings $ 500
If there were no further changes in the London forward price or NYMEX futures price, the entries would unwind on 30 June as follows:
Cash $ 4,500
New York gold futures contract $ 4,500
To recognize settlement of futures contract.
Cash $ 31,000
Firm commitment (liability) 4,000
Sales $ 35,000
To recognize sale of gold contracted at $310/troy ounce but hedged to forward price of $350/troy ounce.
Example 2:
Fair value hedge of a firm commitment using a futures contract
On 1 January 20X1, a gold mining operation enters into a fixed-price contract
to deliver 100 troy ounces of gold on 30 June 20X1 to a customer in London at a price of $310/troy ounce,
the forward price of gold on 1 January 20X1 for delivery in London on 30 June 20X1.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and the company has elected, the NPNS scope exception in ASC 815.)
The company would have preferred for the sales contract to have been at the market price on the date of delivery,
but as a concession to its customer offered it a fixed-price contract.
To hedge against the potential opportunity loss in revenue due to an increase in gold prices,
on 1 January 20X1,
the company enters into a New York Mercantile Exchange (NYMEX) futures contract
to purchase 100 troy ounces at a price of $300/troy ounce for delivery in June.
The NYMEX contract requires delivery in New York.
--------------------
Through the first quarter of 20X1,
the company would have made entries (ignoring margin requirements) totaling the following:
New York gold futures contract $ 4,500
Sales $ 4,500
To recognize change in the fair value of futures contract.
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Sales $ 4,000
Firm commitment (liability) $ 4,000
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To recognize the change in the fair value of the firm contract to sell gold at a price of $310 when the current forward price is $350/troy ounce.
The net effect of the above entries is an increase in income of $500
due to differences in the changes in fair value of the firm commitment vs. the changes in fair value of the NYMEX futures contract.
This difference can be calculated as follows:
Change in New York futures price ($345 — $300) $ 45
Change in London forward price ($350 — $310) 40
Difference $ 5
x 100 ounces
Net effect on earnings $ 500
If there were no further changes in the London forward price or NYMEX futures price, the entries would unwind on 30 June as follows:
Cash $ 4,500
New York gold futures contract $ 4,500
To recognize settlement of futures contract.
Cash $ 31,000
Firm commitment (liability) 4,000
Sales $ 35,000
To recognize sale of gold contracted at $310/troy ounce but hedged to forward price of $350/troy ounce.
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Example 2:
Fair value hedge of a firm commitment using a futures contract
On 1 January 20X1, a gold mining operation enters into a fixed-price contract
to deliver 100 troy ounces of gold on 30 June 20X1 to a customer in London at a price of $310/troy ounce,
the forward price of gold on 1 January 20X1 for delivery in London on 30 June 20X1.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and the company has elected, the NPNS scope exception in ASC 815.)
The company would have preferred for the sales contract to have been at the market price on the date of delivery,
but as a concession to its customer offered it a fixed-price contract.
To hedge against the potential opportunity loss in revenue due to an increase in gold prices,
on 1 January 20X1,
the company enters into a New York Mercantile Exchange (NYMEX) futures contract
to purchase 100 troy ounces at a price of $300/troy ounce for delivery in June.
The NYMEX contract requires delivery in New York.
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Effect of the hedge on the income statement
At the conclusion of the transaction and after the effect of the hedge,
the company has effectively sold the gold at the June spot price of $350/troy ounce,
even though the contract was at a price that was fixed in January
(i.e., the company “unlocked the fixed-price contract).
It also recognized a $500 gain from the mismatch caused by using the change in the NYMEX futures to hedge the change in London forward prices.
However, this mismatch was not large enough to invalidate the hedge
(change in fair value of derivative/ change in fair value of firm commitment = $4,500/$4,000, or 112.5%).
Because ASC 815 requires all of the effects of the hedging instrument to be presented in the same income statement line item as the effects of the hedged item,
the company recorded $500 of net mismatch in sales.
Example 2:
Fair value hedge of a firm commitment using a futures contract
On 1 January 20X1, a gold mining operation enters into a fixed-price contract
to deliver 100 troy ounces of gold on 30 June 20X1 to a customer in London at a price of $310/troy ounce,
the forward price of gold on 1 January 20X1 for delivery in London on 30 June 20X1.
(The firm commitment is not accounted for as a derivative contract because it qualifies for, and the company has elected, the NPNS scope exception in ASC 815.)
The company would have preferred for the sales contract to have been at the market price on the date of delivery,
but as a concession to its customer offered it a fixed-price contract.
To hedge against the potential opportunity loss in revenue due to an increase in gold prices,
on 1 January 20X1,
the company enters into a New York Mercantile Exchange (NYMEX) futures contract
to purchase 100 troy ounces at a price of $300/troy ounce for delivery in June.
The NYMEX contract requires delivery in New York.
--------------------
Effect of the hedge on the income statement
At the conclusion of the transaction and after the effect of the hedge,
the company has effectively sold the gold at the June spot price of $350/troy ounce,
even though the contract was at a price that was fixed in January
(i.e., the company “unlocked the fixed-price contract).
It also recognized a $500 gain from the mismatch caused by using the change in the NYMEX futures to hedge the change in London forward prices.
However, this mismatch was not large enough to invalidate the hedge
(change in fair value of derivative/ change in fair value of firm commitment = $4,500/$4,000, or 112.5%).
Because ASC 815 requires all of the effects of the hedging instrument to be presented in the same income statement line item as the effects of the hedged item,
the company recorded $500 of net mismatch in sales.
