(( Reference only to answer the question))

P 13-3

Cash-flow hedges, interest rate swap

On January 1, 2011, Cam borrows $400,000 from Ven. The five-year term note is a variable-rate one in which the 2011 interest rate is determined to be 8 percent, the LIBOR rate set for a particular year equal to the beginning-of-the-year LIBOR rate +2 percent. Interest payments are due on December 31 each year and are computed assuming annual compounding.

Also on January 1, 2011, Cam decides to enter into a pay-fixed, receive-variable interest rate swap arrangement with Gra. Cam will pay 8 percent.

Assume that the LIBOR rate on December 31, 2011, is 5 percent.

• Why is this considered a cash-flow hedge instead of a fair-value hedge?
• Do you think that this hedge would be considered effective and therefore would qualify for hedge accounting?
• Assuming that this is hedge relationship qualifies for hedge accounting:
• Determine the estimated fair value of the hedge at December 31, 2011. Recall that the hedge contact is in effect for the 2012, 2013, 2014, and 2015 interest payments.
• Prepare the entry at December 31, 2011, to account for this cash-flow hedge as well as the December 31, 2011, interest payment.
• Assuming that the LIBOR rate is 5.5 percent on December 31, 2012, prepare all the necessary entries to account for the interest rate swap at December 31, 2012, including the 2012 interest payment.

 

 

 

( THE QUESTION TO BE ANSWERED)

 

13-4

 

 

Refer to Problem P 13-3 and assume that instead of initially signing a variable-rate loan, Cam receives a fixed rate of 8 percent on the loan on January 1, 2011. Instead of entering into a pay fixed, receive-variable interest rate swap with Gra, Cam enters into a pay-variable, receive-fixed interest rate swap. The variable portion of the swap formula is LIBOR rate + 2%, determined at the end of the year to set the rate for the following year. The first year that the swap will be in effect is for interest payments in 2012.
Assume that the LIBOR rate on December 31, 2011, is 7 percent.
1. Why is this considered a fair value hedge instead of a cash flow hedge?
2. Do you think that this hedge would be considered effective and therefore would qualify for hedge accounting?
3. Assuming that this hedge relationship qualifies for hedge accounting:
a. Determine the estimated fair value of the hedge at December 31, 2011. Recall that the hedge contract is in effect for the 2012, 2013, 2014, and 2015 interest payments.
b. Prepare the entry at December 31, 2011, to account for this fair value hedge as well as the December 31, 2011, interest payment.
4. Assuming that the LIBOR rate is 6.5% on December 31, 2012, prepare all the necessary entries to account for the interest rate swap at December 31, 2012, including the 2012 interest payment.