CASE 5
Cash Flow Hedge of Variable-Rate Debt
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4-1
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, 5year 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
CASE 5
Cash 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 debt—no change in value
given that rates reset to market
– Pay-fixed 6%, receive-variable interest rate
swap—increases in value
4-2
CASE 5
Cash Flow Hedge of Variable-Rate Debt
Variable-rate debt
Variable rate
Semiannual debt payment
Swap receive variable
Swap fixed payment
Net debt and swap
interest expense
6/30/X1
100,000,000
5.7%
2,850,000
(2,850,000)
3,000,000
12/31/X1
100,000,000
6.7%*
3,350,000
(3,350,000)
3,000,000
3,000,000
3,000,000
*Rate increased 100 basis points on 7/1/X1 reset.
4-3
CASE 5
Cash Flow Hedge of Variable-Rate Debt
6/30/X1
Fair value of pay
6% swap
4-4
3,804,0001
12/31/X1
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
CASE 5
Cash Flow Hedge of Variable-Rate Debt
At 6/30/X1
Interest expense
2,850,000
Interest payable
To record debt interest accrual
2,850,000
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
To record fair value of swap excluding accrual
4-5
3,804,000
CASE 5
Cash 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.
4-6
CASE 5
Cash Flow Hedge of Variable-Rate Debt
At 12/31/X1
Interest expense
Interest payable
3,350,000
3,350,000
To record debt interest accrual ((.067 × $100m)/2)
Interest receivable
Interest payable
Interest expense
3,350,000
3,000,000
350,000
To record swap accrual (receive 6.7% and pay 6%)
OCI
367,000
Swap asset
To record fair value change of swap excluding accrual
4-7
367,000
CASE 5
Cash Flow Hedge of Variable-Rate Debt
4-8
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XYZ documented that the swap and variablerate debt terms for the nominal amounts,
payment frequency, reset dates, and maturity
match
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The effectiveness of the hedge was
demonstrated throughout the term of the
hedge
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This hedge is not exposed to basis risk because
the swap and debt each have the identical
variable rate (LIBOR)
CASE 6
Fair Value Hedge of Fixed Rate Debt
Long-Haul Method
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4-9
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
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.
4-10
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 debt’s 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
4-11
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.
4-12
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 swap’s 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 bond’s present value,
calculated based on its yield at hedge inception, adjusted for
changes in the LIBOR swap rate (DIG Issue E7)
4-13
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
Less:
Swap accrual for the period 4/3-6/30
$4,252,000
Net Swap Loss
$4,016,000
236,000
(Interest rate shift assumed to be a parallel shift in the yield curve)
4-14
CASE 6
Recording Hedge Activity
4/30/00
No entry required because swap entered into at-the-money
6/30/00
Dr
Debt
Cr
Earnings
Dr
Cr
Earnings
Swap Liability
3,775,620
3,775,620
4,016,000
4,016,000
To record swap and debt fair value changes attributable to
changes in the LIBOR swap rate, excluding accruals
4-15
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 debt’s 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
4-16