CASE 5 Cash Flow Hedge of VariableRate Debt

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CASE 5 Cash Flow Hedge of Variable-Rate Debt

• On 1/1/X1, XYZ, a B rated entity, issued a 100
  million note at LIBOR, semiannual payments and
  semiannual variable-rate reset dates,
  noncallable, 5-year term
• Current LIBOR is 5.7
• XYZ wants to lock in a 6 fixed rate XYZ enters
  into an interest-rate swap to pay 6 fixed and
  receive LIBOR
• Swap terms include a 100 million notional
  principal, a 5-year term, and semiannual
  variable-rate reset
• At hedge inception, the fair value of the swap is
  zero

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CASE 5Cash Flow Hedge of Variable-Rate Debt

• Assume that during the six-month period ended
  6/30/X1, interest rates increase. Also, a
  comparable term pay-fixed, receive-variable
  interest rate swap is priced at 6/30/X1 at a 7
  pay-fixed rate. Given these facts, the direction
  of fair value changes are as follows
• Variable-rate debtno change in value given that
  rates reset to market
• Pay-fixed 6, receive-variable interest rate
  swapincreases in value

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CASE 5Cash Flow Hedge of Variable-Rate Debt
6/30/X1 12/31/X1 Variable-rate
debt 100,000,000 100,000,000 Variable rate
5.7 6.7 Semiannual debt payment 2,850,000 3,350
,000 Swap receive variable
(2,850,000) (3,350,000) Swap fixed
payment 3,000,000 3,000,000 Net debt and swap
interest expense 3,000,000 3,000,000 Rate
increased 100 basis points on 7/1/X1 reset.
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CASE 5Cash Flow Hedge of Variable-Rate Debt
6/30/X1
12/31/X1 Fair value of pay 6 swap
3,804,0001 3,437,0002 1 PV of nine 500,000
semiannual payments, discounted at 3.5 per
period 2 PV of eight 500,000 semiannual
payments, discounted at 3.5 per period
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CASE 5Cash Flow Hedge of Variable-Rate Debt
At 6/30/X1 Interest expense
2,850,000 Interest payable 2,850,000 To
record debt interest accrual Interest receivable
2,850,000 Interest expense
150,000 Interest payable 3,000,000 To record
swap accrual (receive 5.7 and pay-fixed
6) Swap asset 3,804,000 OCI 3,80
4,000 To record fair value of swap excluding
accrual
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CASE 5Cash Flow Hedge of Variable-Rate Debt
At 12/31/X1, rates have remained the same as at
6/30/X1 and the swap market value has decreased
to 3,437,000 due the 12/31/X1 payment and time
passage. Interest rates reset on 6/30/X1 for
both the swap and variable-rate debt reflecting a
100 basis point increase in LIBOR.
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CASE 5Cash Flow Hedge of Variable-Rate Debt
At 12/31/X1 Interest expense
3,350,000 Interest payable 3,350,000 To
record debt interest accrual ((.067
100m)/2) Interest receivable
3,350,000 Interest payable
3,000,000 Interest expense
350,000 To record swap accrual (receive 6.7 and
pay 6) OCI 367,000 Swap asset
367,000 To record fair value change of swap
excluding accrual
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CASE 5Cash Flow Hedge of Variable-Rate Debt

• XYZ documented that the swap and variable-rate
  debt terms for the nominal amounts, payment
  frequency, reset dates, and maturity match
• The effectiveness of the hedge was demonstrated
  throughout the term of the hedge
• This hedge is not exposed to basis risk because
  the swap and debt each have the identical
  variable rate (LIBOR)

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CASE 6 Fair Value Hedge of Fixed Rate Debt
Long-Haul Method

• On 4/3/00, GlobalTechCoSub issues at par a
  non-callable, 5-year, 100 million note at 8
  fixed interest, semiannual payments (debt is
  rated A1)
• On 4/3/00, GlobalTechCo also enters into a 5-year
  interest rate swap 101,970,000 notional amount,
  pay LIBOR plus 78.5 basis points, receive fixed
  at 8, semiannual settlement and interest reset
  dates
• Net interest outflow LIBOR plus 78.5 bps
  (current LIBOR at 6.29)
• Swap is at-market, therefore, no premium required

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CASE 6 Fair Value Hedge of Fixed Rate Debt
Long-Haul Method

• Hedged item 100 million, 5-year, 8 percent
  fixed rate, non-callable debt
• Hedge Strategy Eliminate debt fair value changes
  attributable to changes in the LIBOR swap rate by
  converting interest payments to LIBOR based
  variable-rate.
• Hedging instrument Interest rate swap, terms
  pay LIBOR plus 78.5 basis points, receive 8
  fixed rate. Semiannual swap settlement and rate
  reset at /3 and 10/5. Swap fair value at hedge
  inception 0.

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CASE 6 Fair Value Hedge of Fixed Rate Debt
Long-Haul Method

• Statement of hedge effectiveness A
  duration-weighted hedge ratio calculates the swap
  notional amount necessary to offset the debts
  fair value changes attributable to changes in the
  LIBOR swap rate.
• PV01 debt 4.14
• PV01 swap 4.06
• Hedge ratio PV01 debt/PV01 swap 4.14/4.06
  1.0197
• Swap notional 1.0197 x 100 million
  101,970,000

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CASE 6 Fair Value Hedge of Fixed Rate Debt
Long-Haul Method

• Statement of hedge effectiveness (continued)
• Therefore, a 1 basis point shift in the
  GlobalTechCoSub 100 million debt issuance equals
  a 1 basis point shift in 101,970,000 notional of
  the LIBOR based swap.

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CASE 6 Fair Value Hedge of Fixed Rate Debt
Long-Haul Method

• Statement of hedge effectiveness (continued)
• The swap accrual for its semi-annual settlement
  is excluded from the swaps calculation of its
  change in fair value. The debts interest accrual
  is also excluded from its calculation of changes
  in fair value. This simplifies the hedge
  effectiveness calculation
• On a prospective and retrospective basis, hedge
  effectiveness will be assessed based upon a
  regression analysis of changes in the LIBOR swap
  rate and changes in the bonds present value,
  calculated based on its yield at hedge inception,
  adjusted for changes in the LIBOR swap rate (DIG
  Issue E7)

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CASE 6 Effect of 100 Basis Point Rate Increase
at 6/30/00

• 6/30/00 swap fair value change,
• Receive 8 fixed, pay LIBOR
• 78.5 basis points swap 4,252,000
• Less
• Swap accrual for the period 4/3-6/30 236,000
• Net Swap Loss 4,016,000
• (Interest rate shift assumed to be a parallel
  shift in the yield curve)

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CASE 6 Recording Hedge Activity

• 4/30/00
• No entry required because swap entered into
  at-the-money
• 6/30/00
• Dr Debt 3,775,620
• Cr Earnings 3,775,620
• Dr Earnings 4,016,000
• Cr Swap Liability 4,016,000To record
  swap and debt fair value changes attributable to
  changes in the LIBOR swap rate, excluding accruals

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CASE 6 Ineffectiveness Recorded at 6/30/00

• The net earnings impact of the hedge was 240,380
  due to some imprecision in the calculated hedge
  ratio. The hedge would continue to qualify for
  hedge accounting provided the regression analysis
  justified the result
• In practice, this result will be common
• The debts subsequent period changes in value
  attributable to changes in the LIBOR swap rate
  are computed by comparing its prior period
  present value (not the same as its fair value) to
  its current period present value, excluding
  accrued interest