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					Mexcobre Case
Using Swaps to Increase Debt: The Real World Case of a Copper Swap
Bob Jensen at Trinity University              http://www.trinity.edu/rjensen
The HTML version of this case can be found at
          http://www.trinity.edu/rjensen/acct5341/speakers/133spraos.htm
Source: This is an extension of a real world copper swap reported by Paul B. Spraos in "The Anatomy of a
          Copper Swap," Corporate Risk Management and on "Mexcobre Loan Deal Repays
          Debt," Corporate Finance, August 1989. It is reproduced in Managing Financial Risk:
          A Guide to Derivative Products, Financial Engineering, and Value Maximization by
           C.W. Smithson, C.W. Smith, Jr., and D.S. Wilford (Chicago: Irwin Professional Publsihing)
          This write up, with both questions and answers was created by Bob Jensen

Acknowledgement: I am grateful to Rashad Abdel-Khalik for making me aware of this illustration during
         his presentation at the Tenth Asian-Pacific Conference on International Accounting Issues,
         Maui, October 26, 1998.




Table of Contents
          Introduction
          Why do companies enter into interest rate swaps?
          How did Sogem from Belgium eliminate political risk?
          How did a copper swap reduce copper price fluctuation risk?
          Case Questions and Assignments
                      Question 01
                      Question 02
                      Question 03
                      Question 04
                      Question 05
                      Question 06
                      Question 07
                      Question 08
                      Question 09
                      Question 10

How did swaps reduce copper price fluctuation risk?
Introduction
Shortly after Salamon Brothers invented the interest rate swap financial instruments derivative in a
contract between IBM and the World Bank in 1981, this type of derivative was used to manage risk
 in a copper mining operation in a Mexican company called Mexicana de Cobre (Mexcobre), a
subsidiary of a copper mining group in Mexicao called Group Mexico. The transaction eventually
involved ten banks in several nations, a Belgian customer, multiple foreign currencies, and Mexcobre itself.
Why do companies enter into swaps?

In a simple (plain) vanilla swap, the purpose is usually to swap variable rate interest obligations for fixed
rate obligations. The firm with variable rate debt can often swap for a better deal than can be obtained
 loan. Reasons for this can be complicated. Sometimes it is a matter of timing. For example, when
a firm acquires variable rate debt, that type of debt may appear to be the best deal. With the
 passage of time, the firm may change its preference toward fixed rate debt. Negotiating an interest
rate swap may have lower transactions cost than paying off the variable rate debt and refinancing
with fixed rate debt. The counter party in the swap, on the other hand, may be willing to speculate
or otherwise prefer to swap for variable rate payments.

In more complex situations, there may be capital market inefficiencies that make interest rate swaps
advantageous. Firms enter into swaps to either speculate or to hedge interest rate risk. In some
instances, fixed rate debt cannot be obtained directly at any rate. For example, suppose a
company has low or even zero credit standing in a certain nation and negotiates to swap interest
payments with a company that has high credit standing in that nation. Swaps are often brokered
by international banks of high credit standing that eliminate credit risk of both parties to a swap. In
any case, swap cash flows are usually netted against each other so the default risk would be low even if
there were no payment guarantees. Direct loans often entail credit risk, especially if the borrower is
from one nation and the lender is from another nation. Interest rate swaps account for over 70% of
all financial instrument derivatives contracts. The reason is that they are a means of reducing
credit risk, transactions costs, and market risk in hedging and speculating contracts.

The Mexcobre copper exporting subsidiary of Groupo Mexico faced such enormous financial price risks
that it was effectively denied access to international debt markets. At the same time, it was paying
burdensome 23% interest rate to the Mexican Government. Through a complex international
swap arrangement, Mexcobre managed to replace its high cost $251 million debt with a 11.48%
fixed rate interest payment.




How did Sogem from Belgium eliminate political risk?
A crucial part of the case came in reducing political risk in Mexico. Since so much labor is involved
in copper mining, the Mexican government is not likely to take drastic measures or impose taxes that
impede the mining and sale of copper. However, the government might impede cash flows. For
example, suppose the Mexican government chooses to tax or otherwise impede interest payments going
to the ten banks outside of Mexico in an effort to protect its own loans to Mexican companies. The
ten outside banks hedged against such political risk by avoiding cash payments from Mexico. This
was accomplished with a purchase contract in which a firm called Sogem in Belgium agreed to purchase
nearly 4,000 tons of copper each month at spot rates on the London Mercantile Exchange (LME).
Payments, however, went into an escrow account in a New York bank. These funds, in turn, were
used to service $251 million loaned to Mexcobre by ten banks.




How did a copper swap reduce copper price fluctuation risk?

If copper prices plunged, there was a possibility that the balance of funds in escrow in New York would
not be sufficient to service the debt on the $251 million in loans to Mexcobre by ten banks.




The Bank in New York controlling the escrow account acted at the request of the ten lending banks to
hedge against copper price movements. Bank Paibus was willing to swap with the escrow fund for
 variable copper prices and guarantee a fixed monthly price or $2,000 per ton on 4,000 tons per month..

Case Questions

Question 01
Discuss the various types of risks faced by the ten banks if they simply loaned $210 million to Mexican
de Cobre (Mexcobre) on at a fixed interest rate and did not engage in the other contracting mentioned
in the case. Discuss both direct and indirect risks. Do not assume any Sogem or Banque Paribus
hedging when answering this question.

[Hint: See the term "risk" in Bob Jensen's SFAS 133 Glossary at http://www.trinity.edu/rjensen/133glosf.htm ]



Question 02
Why was Sogem in Belgium hedging contract demanded by the ten banks? Ignore the copper
price swap with Banque Paribus when answering Question 2.

Are the hedged items (i.e. the fixed interest payments on the loan to Mexcobre) firm commitments
or forecasted transactions? Answer in terms of the notional, underlying, and disincentive for nonperformance
on each loan payment.

What implications does this have for the note being a hedged item under Paragraph 21d or 29e
of SFAS 133? Can the Sogem hedge affect Other Comprehensive Income (OCI)?

Question 03
Does the net effect of all this transacting result in fixed-rate or variable-rate loan to Mexcobre?
Explain your answer in terms of what happens to any "excess" profits from the copper price swap.


Question 04
After all the contracts in this case are signed, what risks have been assumed by both Banque Paribus and Sogem in Belgium?
How can these risks be hedged by Sogem and Banque Paribus?
You may assume derivatives not mentioned in this case as well as those mentioned in the case.
Explain your answer.


Question 05
In Question 1, you discussed the various types of risks faced by the ten banks if they simply loaned
$251 million to Mexican de Cobre (Mexcobre). Aside from transactions costs in arranging all the
contracts (especially the Sogem contract and the Banque Paribus contract), what risks remain to
 justify charging 11.48% to Mexcobre rather than a much lower interest rate since political risks and
copper price risks have been hedged? In other words, why wouldn't the loan be attractive to
U.S. banks for 8% if Mexcobre incurred all the transactions costs of negotiating the hedges with
Sogem and Banque Paribus?


Question 06
How does Professor Rashad Abdel-Khalik argue that neither the New York Bank holding the escrow
fund nor the ten banks who loaned the $251 million would be allowed to report the copper price swap
with Bank Paibus as a cash flow hedge derivative under SFAS 133? Do you agree? Explain your
Explain your position as to whether this constitutes commodity-indexed interest and principal
payments in the context of SFAS 133.

[Hint: See Paragraph 61i on Page 43 of SFAS 133.]


Question 07
In Question 7 and all remaining questions, assume that all ten banks comprise
just one bank called the "New York Bank." This simplifies the accounting. You
may ignore any cash flows owed to the ten banks as separate entities.

In Question 7 and all remaining questions, assume the New York Bank closes its
revenue and expense accounts to Retained Earnings at the end of each month.

For this question, assume there is no $251 million loan to Mexcobre. Instead, you may assume that
the bank has some type of income from Sogem that is paid in cash each month equal to the LME
spot price of copper multiplied by 4,000 tons each month. In other words, pretend for now that the New
York bank can retain all cash flows from its swap contract with Banque Paribus. Assume the New
York bank in this instance chooses to account for the copper swap as a cash flow hedge under SFAS
133 (ignoring any argument that SFAS 133 might not apply). You are to make journal entries for only
the copper price hedge between the New York Bank and Banque Paibus. Ignore the fact that ten banks
are involved and assume all net swap payments flow to or from the New York Bank.

What is the journal entry made by the New York Bank at the date the swap is initiated on January 1,
19x1? What is the entry made on January 31, 19x1 by this bank to record the cash payment from
Sogem in Belgium for 4,000 tons of copper at $1,850 per ton. Limit your answer to the swap
accounting and do not attempt to account for loan of $251 million in this question or the return of any
surplus payments to Mexcobre. Assume that in the first month, the Banque Paribus honors its swap
obligation by sending the New York Bank a check for the net difference between $2,000 per ton versus
the spot price of $1,850 per ton for 4,000 tons of copper. What is the journal entry for the New York
bank to account for the swap payment? What are the journal entries for Banque Paribus at the
inception of the swap on January 1, 19x1 and after the first net swap cash payment on January 31,
19x1?

When applying SFAS 133 rules, use the data shown in the table below:
Question 7 of the Mexcobre Case (No ineffectiveness)
            Current     Swap        Net       Journal    Copper     Assumed
            Copper Receivable Price            Entry      Swap        Swap
 Month Price/ton        Price Difference       Date     Revenue       Value
   0                                          01/01/x1                  $0
   1        $1,850     $2,000     ($150)      01/31/x1 ($600,000) ($16,942,276)
   2        $2,100     $2,000      $100       02/28/x1 $400,000    $11,064,274
   3        $2,400     $2,000      $400       03/31/x1 $1,600,000 $43,320,951

In Question 7, restrict your entries to cash flows from Sogem and the SFAS 133 entries for the
copper price swap. Entries for the Mexcobre note will be made in a later question.

Please use the following Chart of Accounts in your journal entries:

           Cash
           Copper price swap receivable/payable
           Loss/gain on copper price speculation (use this account with all cash flows in Questions 7 and 8).
           Other comprehensive income
           Retained Earnings


Question 08
Repeat the Question 7 accounting for the February 28 and March 31 net cash flows from both the
Sogem and Banque Paribus contracts. Accumulate the balances for Cash, Other Comprehensive
Income, and Retained Earnings from Question 7. Assume that the LME copper spot prices are
$2,100 for February and $2,400 for March on 4,000 tons of copper each month.

Also draw a graph comparing the monthly increase in cash versus the monthly increase in
retained earnings for January 31, February 28, and March 31. When making the Question 8 journal
entries, use the price and value data given in the Question 7 data table.

At the end of your answers to Question 8, discuss whether this copper price swap was effective in
terms of SFAS 133 criteria for hedge effectiveness. Explain your answer.


Question 09
Professor Rashad Abdel-Khalik argues that value at risk (VAR) cannot be computed for the ten banks.
Do you agree? What other SEC alternatives are available for disclosing the risks of the Mexcobre
contracting in this case?

           [Hint: Look under the term "Disclosure" in Bob Jensen's SFAS 133 Glossary.
           Also read the transcript of a presentation by Professor Walter Teets and then read the
           comments by Professor Rashad Abdel-Khalik.]


Question 10
For this question, assume that the one New York bank loaned the entire $251 million to Mexcobre.
If you disagree with Professor Rashad Abdel Khalik that SFAS 133 accounting would not apply to
the New York Bank, what accounting would you recommend at the inception of each contract and with
the net swap cash flows mentioned in Question 7 and 8. Unlike in Question 7, assume that surplus
funds from high copper prices are returned monthly to Mexcobre above and beyond the 11.48%
interest rate that equates to 0.95667% per month. Also limit your answer to the contract to loan
$251 million, the contract between the New York Bank and Sogem, the contract with Banque Paribus,
and the return of surplus funds to Mexcobre. Assume that the loan principal is amortized over 38
months much like mortgage note amortization in the calculation of loan payments to the New York
 bank at 0.95667%. In other words, each net swap payment from the Banque Paribus is to be
added to the Sogem payment. At the end of each month, the New York Bank deducts a monthly
loan payment from the fund accumulated variable payments from Sogem and the net swap payments
 from Banque Paribus. Any surplus is then sent to Mexcobre each month.

In summary, you are to make the New York Bank's journal entries for the following:

           1. $251 million loan to Mexcobre on January 1, 19x1;

           2. the Banque Paribus swap contract on January 1, 19x1;

           3. the variable monthly payments from Sogem on January 31, February 28, and March 31
                       assuming 4,000 tons per month at spot prices of $1,850 per ton in January,
                       $2,100 per ton in February, and $2,400 per ton in March;

           4. the monthly net copper swap receipts or payments from Bank Paibus on January 31,
                     February 28, and March 31 on fixed swap receipts of $2,000 per ton and swap
                     payments at the same prices used by Sogem to transmit the payments each month;

           5. the first three loan payments (principal and interest) from the escrow fund to the New
                          York bank on January 31, February 28, and March 31, 19x1;
           6. The three monthly surplus payments to Mexcobre in 19x1.

In addition, you are to prepare the $251 loan amortization schedule across 38 months and show the
interest expense, principal reduction, and total loan payment each month that is deducted from
the cash payments from Sogem and Banque Paribus in each of the 38 months. Discuss why the loan
would probably not be periodically remeasured to market value under SFAS 115 rules. Why might this
not affect having to remeasure the copper price swap to market value on the books of the bank?
(Your instructor may prefer to provide you with this loan amortization schedule so that all students work
with the same schedule.)

When making the SFAS 133 journal entries for the swap, use Question 7 table.

Please use the following Chart of Accounts in your journal entries:

                       Cash
                       Copper price swap receivable/payable (actually an optional account)
                       Notes receivable - Mexcobre
                       Interest expense/revenue (this account is not used in Questions 7 and 8)
                       Loss/gain on copper price speculation (use this account only in Questions 7, 8, and 12)
                       Accounts payable - Mexcobre (in Question 10, any surplus funds are sent to Mexcobre monthly)
                       Retained Earnings

Question 11
Compute and compare the rate of return to the New York Bank in Question 10 for each of the
first three months. Compare this with the rate of return that would be obtained each month
if the surplus funds were not returned to Mexcobre. In order to simplify the calculation of this rate of
return, compute each month's rate of return as the ratio of that month's net income from the Mexcobre
transactions divided by the beginning balance of the note's principal still outstanding. You are to
compare the solutions with versus without transfer of surplus funds to Mexcobre.


Question 12
Repeat the January, February, and March answers for Question 10 assuming that there is no copper
price swap with Banque Paibus. In order to simplify the calculation of the rate of return in Question 12,
compute each month's rate of return as the ratio of that month's net income from the Mexcobre
transactions divided by the beginning balance of the note's principal still outstanding. You are to
compare the solutions with versus without transfer of surplus funds to Mexcobre. In other words, you
must provide two alternative sets of journal entries. Assume that the surplus funds sent each month
are either zero (if the copper price declines below the breakeven point) or positive (equal to the surplus
above the monthly breakeven point)

A major question here is whether to include the increments to Other Comprehensive Income (OCI) in
the numerator of the rate of return calculations when surplus funds are not returned to Mexcobre. For
Question 12, please add OCI increments to the numerator of the rate of return calculations.

Make all journal entries for the contracts with Mexcobre and Sogem. Assume that the note is
maintained under amortized historical cost and is not adjusted for fair market value. Then compare all
your journal entries for Question 12 versus Question 10. Please discuss the impact of the swap on
 the New York Bank.
After you finish the journal entries, compute the breakeven price of copper for which the New York Bank will exactly earn its con
will exactly earn its contracted 11.48% per year or 0.9567% per month. Then comment on the impact of varying copper prices
of varying copper prices when surplus funds above the breakeven copper price are returned versus not returned to Mexcobre
returned to Mexcobre.

When making the SFAS 133 journal entries for the swap, use Question 7 table.

Please use the same account names that are listed in the Chart of Accounts for Question 10.


Question 13
From an accounting theory standpoint, do you think SFAS 133 accounting for the Mexcobre
transactions would help investors more easily analyze the risk management practices of the
New York bank? (One bank was assumed in Questions 7-12 in order to simplify prorationing
of the returns among the ten banks actually involved in the transaction.)

If either the Sogem or the Banque Paribus contracts are booked and adjusted to fair value (no
matter what the rules are under SFAS 133 or IAS 39), do you think that adjusting to fair value
will help or hinder investor analysis of the New York bank?

When answering this question first present arguments on both sides of each issue. Then reason
out your own conclusions.
33glosf.htm ]




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estions 7 and 8).
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8)
tions 7, 8, and 12)
ent to Mexcobre monthly)
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sus not returned to Mexcobre.




n
Mexcobre Case
Using Swaps to Increase Debt: The Real World Case of a Copper Swap
Bob Jensen at Trinity University       http://www.trinity.edu/rjensen
The HTML version of this case can be found at
        http://www.trinity.edu/rjensen/acct5341/speakers/133spraos.htm




Teaching Note:
Dennis Beresford and many other accounting professors and practitioners argue that SFAS 133 is too complex for
        financial statement preparers and investors. One simplification being advocated by Dennis Beresford (Journal of
        Accountancy , March 1999, pp. 65-67), the International Accounting Standards Committee (IASC), and many
        others is to adjust all derivative financial instruments to fair value and delete the enormous complexity of
        making decisions as to what contracts must be versus what contracts cannot be adjusted to fair value.

This Mexcobre Case illustrates a real-world instance where, in my analysis, adjusting derivative instruments to fair
        values is highly misleading to investors. This would be true even if the particular derivative instruments in
        this case were traded in markets that are wide and deep (which is not the situation in the actual case).
        The case actually supports the arguments of many bankers who contend that SFAS 133 leads to
        misleading financial statements.

I recommend giving this case to students as an assignment or take home examination. I allow my students to use
        the Internet and any reference materials that they choose to use as long as the cite the sources.

I generally end up giving my students the Sheet 3 amortization schedule that is called for in Question 10. If they
          prepare their own schedule, it makes grading more difficult in some of the other questions if they
          do not get the same schedule as is shown in Sheet 3.
When solving the case I tell my students to first think about using my SFAS 133 Glossary as a starting point
       when answering the questions below. That Glossary is at
       http://WWW.Trinity.edu/rjensen/acct5341/speakers/133glosf.htm

Case Questions and Bob Jensen's Answers

Question 01
Discuss the various types of risks faced by the ten banks if they simply loaned $210 million to Mexican
de Cobre (Mexcobre) on at a fixed interest rate and did not engage in the other contracting mentioned
in the case. Discuss both direct and indirect risks. Do not assume any Sogem or Banque Paribus
hedging when answering this question.

[Hint: See the term "risk" in Bob Jensen's SFAS 133 Glossary at http://www.trinity.edu/rjensen/133glosf.htm ]

Possible political risks are also discussed in Question 2 and in the case itself.

Credit risk is relatively high, but there is almost always credit risk in foreign loans. An important
consideration in any foreign loan is legal jurisdiction. If Mexcobre has the funds and simply decides to
stop making payments on the $210 million loan, it is much harder to seek legal recourse in Mexico
vis-à-vis the United States. This is one possible reason that the ten lending banks worked out a
payment deal through Sogem in Belgium. Mexcobre is not likely to stop selling copper to
a very large customer at current market (spot) rates. The contract with Sogem virtually eliminates
credit risk on the $210 million loan except in the case where Sogem stops producing copper.
Protecting against the risk that Mexcobre will stop producing copper is very difficult to achieve
without expensive or politically-difficult third party guarantees.

The are various other types of risk including foreign currency and interest rate risk. These risks
are discussed in SFAS 133, Pages 184-186. Other risks are mentioned in Paragraph 408.

Aside from the political risk discussed in Question 2, a direct loan to Mexcobre is like most any foreign
fixed-rate loan. Foreign currency risk could be passed on to Mexcobre by writing the payment
terms in U.S. dollars rather than Mexican pesos. Interest rate risk is always unknown, but if the U.S.
banks are happy with the level of fixed interest rates, they are not subject to cash flows being
dependent upon a variable interest rate.

There are indirect interest rate risks in most any fixed-rate loan. If market interest rates plunge too
low, Mexcobre could refinance at lower rates to get out of the higer fixed rate of interest contracted
with the New York banks. The ability to refinance depends upon the contract clauses and prepayment
penalties. If interest rates soar, any fixed-rate income has an opportunity loss. The ten banks
could possibly make an interest rate swap to hedge against higher interest rates, but finding someone
to swap with for interest on $251 million may be difficult. It would not matter, however, that the
original debtor, however, since the swap would not involve Mexcobre per se.

For the New York banks, there would be a risk that Mexcobre could not get enough copper sales
to meet the cash flow needs to service a direct loan from the New York banks. Disasters such
as earthquakes, hurricanes, floods, civil strive, labor strife, etc. could cause production disruptions.

Whether or not the 10 banks hedge the credit and foreign exchange risks, I was looking for mention of some
of the direct and indirect risks mentioned above.

Question 02
Why was Sogem in Belgium hedging contract demanded by the ten banks? Ignore the copper
price swap with Banque Paribus when answering Question 2.

Are the hedged items (i.e. the fixed interest payments on the loan to Mexcobre) firm commitments
or forecasted transactions? Answer in terms of the notional, underlying, and disincentive for nonperformance
on each loan payment.

What implications does this have for the note being a hedged item under Paragraph 21d or 29e
of SFAS 133? Can the Sogem hedge affect Other Comprehensive Income (OCI)?

Risks of loaning $210 to Mexcobre are somewhat complicated. Of major concern to the ten lending
banks was termed "political risk." This can encompass a wide variety of risks. I suspect that one of
the main concerns was that the Mexican government may be upset about losing its 23% interest
income from its own loans to Mexcobre. If this loan was directly replaced by a $210 million dollar
loan from ten U.S. banks, the Mexican Government might retaliate by imposing taxes or other
restrictions on interest payments from Mexcobre to the U.S. banks. This one incident may not
trigger a retaliation move, but if Mexico's banks and governments begin to lose billions of dollars in
loans transferred outside of Mexico, there may be political pressures to curb the outflow.

The case discusses the importance of reducing political risk in Mexico. Since so much labor is involved
in copper mining, the Mexican government is not likely to take drastic measures or impose taxes that
impede the mining and sale of copper. However, the government might impede loan cash flows. For
example, suppose the Mexican government chooses to tax or otherwise impede interest payments
going to the ten banks outside of Mexico in an effort to protect its own loans to Mexican companies.
The ten outside banks hedged against such political risk by avoiding cash payments from Mexico. This
was accomplished with a purchase contract in which a firm called Sogem in Belgium agreed to purchase
nearly 4,000 tons of copper each month at spot rates on the London Mercantile Exchange (LME).
Payments, however, went into an escrow account in a New York bank. These funds, in turn, were
used to service $210 million loaned to Mexcobre by ten banks.

There is always the risk that Mexcobre will stop shipping copper to Sogem in Belgium. This is the
easiest way to default on the $251 million loan. However, producers are not inclined to sacrifice their
best customers and antagonize their labor unions. Of course disasters such
as earthquakes, hurricanes, floods, civil strive, labor strife, etc. could cause shipping disruptions.

Now consider a fixed rate direct loan to Mexcobre without Sogem's political hedge. The notional on
such a loan is $251 million. The underlying is 11.48% APR. Disincentives for nonperformance are
not mentioned since the banks would not make the loan without Sogem's political hedge. It is safe
to assume, however, that there would be strong disincentives if political risk was not hedged. In
that case the loan repayments would meet the tests of being firm commitments rather than forecasted
transactions.

Only when the political risk was hedged with Sogem did the firm commitment become transformed
into a forecasted transaction. With the Sogem contract, the underlying becomes variable based upon
the LME spot rate of copper.

Without the Sogem hedge of political risk, the loan repayments are firm commitments rather than
forecasted transactions. As such, Paragraph 29e is not relevant. However, Paragraph 21d is one of
of the criteria to be satisfied for a fair value hedge (cash flow hedges are not permitted for firm
commitments). Paragraph 21d reads as follows:

         If the hedged item is all or a portion of a debt security (or a portfolio of similar debt securities) that is
         classified as held-to-maturity in accordance with FASB Statement No. 115, Accounting for Certain
         Investments in Debt and Equity Securities, the designated risk being hedged is the risk of changes in its
         fair value attributable to changes in the obligor's creditworthiness or if the hedged item is an option
         component of a held-to- maturity security that permits its prepayment, the designated risk being hedged
         is the risk of changes in the entire fair value of that option component. (The designated hedged risk for a
         held-to-maturity security may not be the risk of changes in its fair value attributable to changes in market
         interest rates or foreign exchange rates. If the hedged item is other than an option component that permits
         its prepayment, the designated hedged risk also may not be the risk of changes in its overall fair value.)

It is probably safe to assume that the Mexcobre note will be classified as held-to-maturity. It is also
clear that the hedged item is a firm commitment. It then appears that Paragraph 29d is satisfied if
a fair value hedge since the main intent of the hedge is to hedge the "risk of changes it its fair
value attributable to changes in the obligor's creditworthiness." However, the case makes no
mention of the banks wanting to hedge fair value. The purpose of the Sogem hedge is, in my
viewpoint is to hedge the interest payments from Mexcobre. This is an economic hedge, but it
cannot be accounted for as a cash flow hedge under SFAS 133 (since the hedged item is a firm
commitment). Without a cash flow hedge or foreign currency risk, the Sogem in Belgium hedge
could never affect Other Comprehensive Income (OCI) under SFAS 133.

Students might make a valid argument that the Sogem contract is not a derivative instrument since
it does not "derive" its value from an external index or commodity price. It derives its value from the
standpoint of Sogem's willingness to contract for 4,000 tons of copper per month and send the current value of
that copper to the New York banks as Mexcobre's debt service on a loan. If the Segem hedging
contract is not a derivative instrument, than nothing in SFAS 133 pertains to accounting for that contract.

The above reasoning does not apply to the copper price swap with the Banque of Paribus. However,
Question 2 does not pertain to that swap.


Question 03
Does the net effect of all this transacting result in fixed-rate or variable-rate loan to Mexcobre?
Explain your answer in terms of what happens to any "excess" profits from the copper price swap.

The loan is a fixed-rate loan at 11.48% interest rate that equates to 0.9567% per month. However, the
11.48% level remains fixed only so long as the surplus in the escrow account is returned monthly to
Mexcobre. If the surplus is not returned, then the net effect must include gains or losses from the
copper price swap with Banque Paribus. These calculations are required in a later question below.


Question 04
After all the contracts in this case are signed, what risks have been assumed by both Banque Paribus and Sogem in Belgium?
How can these risks be hedged by Sogem and Banque Paribus?
You may assume derivatives not mentioned in this case as well as those mentioned in the case.
Explain your answer.
The Banque Paribas was willing to take on the risk of a copper price loss while at the same time
speculating on copper price increases. This could be a net speculation or it could be that the variable
receipts on this transaction hedge an opposing exposure of Bank Paribas. In any case, Banque
Paibas accepted the variable copper price risk exposure in this illustration. The ten banks that made
the initial loan, however, bear the underlying risk that Mexcobre will be able to ship at least 4,000
 tons of copper to Sogem in Belgium each month.

If Banque Paribus at some future point in time wants to hedge its copper price exposure, it can seek
a counterswap or resort to some other types of derivatives such as forwards, futures, or options on
copper prices. Banque Paribus can also enter into reversing swaps.

Sogem in Belgium assumed the risk of importing 4,000 tons of copper no matter what its needs for
copper in the future. Sogem has no price risk on this copper, but it must import 4,000 tons each month
under its contracts with Mexcobre and the New York Banks. Sogem could hedge its risk
with by taking on short positions to get rid of the copper (e.g., put options, forward contracts, or
futures contracts). The least risky short postion is a purchased call option that does not have to
exercised unless Sogem chooses to use the option to unload unwanted copper.


Question 05
In Question 1, you discussed the various types of risks faced by the ten banks if they simply loaned
$251 million to Mexican de Cobre (Mexcobre). Aside from transactions costs in arranging all the
contracts (especially the Sogem contract and the Banque Paribus contract), what risks remain to
 justify charging 11.48% to Mexcobre rather than a much lower interest rate since political risks and
copper price risks have been hedged? In other words, why wouldn't the loan be attractive to
U.S. banks for 8% if Mexcobre incurred all the transactions costs of negotiating the hedges with
Sogem and Banque Paribus?

The New York banks have hedged most risks other than the fundamental risk that Mexcobre
will fail to ship 4,000 tons of copper to Sogem in Begium each and every month. It is unlikely
that Sogem bore the risk of sending cash payments to New York if the copper was not shipped to
Sogem. the New York Banks could hedge this risk with long postions on copper (e.g., call options,
forward contracts, or futures contracts). The least risky long position would be to purchase a call
option for each month that does not have to be exercised. However, the premiums for such options
make this a costly hedging alternative for an unlikely risk that Mexcobre will not ship the
copper.
Note that the hedges ipso facto justify risk free loan rates. The hedge contracts themselves have risks.
Anything that could impede the cash flows from Sogem and Banque Paribus enters into the risk
analysis. Mexcobre could stop delivering copper to Sogem for a variety of reasons. Sogem could
not live up to the terms of its contract. Banque Paribus could default on the copper swap. Note,
however, that the loss would only be in the net swap flows, and the escrow fund would still receive
the variable spot rate cash flows from Sogem. One advantage of a swap is that the entire "notional"
 is not at risk, Only the net swap flow is at risk, and this is not at risk in may
swaps where the swap broker (e.g., and investment bank) guarantees the net swap cast flows.

Governments that affect Sogem and Banque Paribus could impede cash outflows in a variety of
ways such as taxing cash leaving these countries. Such events are not likely, but they are possible.

Of course there is always the possibility that copper deliveries to Sogem could go below 4,000 tons
per month in the unlikely events of Mexican earthquakes, volcanoes, civil disorder, labor strikes, etc.


Question 06
How does Professor Rashad Abdel-Khalik argue that neither the New York Bank holding the escrow
fund nor the ten banks who loaned the $251 million would be allowed to report the copper price swap
with Bank Paibus as a cash flow hedge derivative under SFAS 133? Do you agree? Explain your
Explain your position as to whether this constitutes commodity-indexed interest and principal
payments in the context of SFAS 133.

[Hint: See Paragraph 61i on Page 43 of SFAS 133.]


He is relying on the provisions in SFAS 133 regarding "clearly-and-closely-related" criteria that
determine when and when not to treat an embedded derivative as a free standing hedging
contract apart from its host contract. Relevant sections of SFAS 133 include SFAS 133 Paragraphs
304-311 in Pages 150-153 and again in Paragraphs 443-450. The closely-related criterion is illustrated
in Paragraphs 176-177on Page 93. Also the FASB reversed its exposure drafft position on compound
derivatives. Examples 12-34 beginning in Paragraph 176 on Page 93 illustrate clearly-and-closely-
related criteria in embedded hybrid derivative instruments. These criteria determine whether an
embedded derivative can be accounted for under SFAS 133 rules. For example, a call option cannot
be an embedded derivative if it is clearly-and-closely-related to a hybrid instrument that is clearly an
equity instrument on a freestanding basis and, thereby, is not subject to SFAS 133 rules. If a
prepayment option on a in a variable rate mortgage is based upon an interest rate index, the option is
clearly-and-closely-related to the host contract and cannot be accounted for separate from its host.
On the other hand, if the option is instead based upon a stock price index such as the Standard and
Poors 500 index, the option is no longer clearly-and-closely-related to the host contract.

Professor Abdel-Khalik spoke his objections as follows (with some tape editing by Bob Jensen):

         So that the question that I'm trying to get at here is the following: Suppose we are the
         FASB and the Security Exchange Commission here in the United States. When looking at
         these banks we are telling them report the value at risk that you're exposed to from this
         derivative. This swaps do not qualify as a hedge under the SFAS 133 --- correct? Because
         they're not clearly-and-closely-related to qualify as hedges. It's very indirect ,and so it did
         not change the value of this loan on the balance sheet. It stays at historical cost. Now this
         hedge here exposes these ten banks to risk.

         When the Mexcobre case is viewed as one transaction, note that the risk at these banks
         are exposed is not from one swap, it's from this swap and this swap, and this dealing of
         copper price exchange. Commodity risk, copper price risk, and foreign currency risk are
         all involved.

Paragraph 61i on Page 43 of SFAS 133 is troublesome in terms of trying to treat the copper price
swap under cash flow hedge accounting rules. The intent of Paragraph 61i is to deny hedge accounting
if any amount of interest and principal payment varies with the a commodity price such as the LME
spot price of copper. The copper price swap with Mexcobre, however, works just the opposite in that
swap payments from the Banque Paribus are fixed no matter what the commodity price of copper
becomes. Since the swap payments are fixed at the exact amount that services the Mexcobre $251
million debt contract, Paragraph 61i, in my viewpoint, does not prevent accounting for the copper price
swap as a cash flow hedge. The swap prevents the bank from benefitting from upside potential of
copper price movements beyond the annual fixed 11.48% yield of the Meccobre note, but the yield
on that hedged note can never go below (or above) that 11.48% rate.

An example of an embedded derivative does not meet the hedging requirement of being clearly and
closely related to the host contract would be what is called a crude oil knock-in note in which the
note payments are guaranteed by the upside potential of crude prices. In that case the minimum cash
yield is fixed at some (usually low) amount with the speculative prospect of going higher if oil price
rise. In that instance, however, the ultimate yield is not fixed irrespective of price increases beyond a
certain threshold.
In my opionion, the copper price swap clearly qualifies as a cash flow hedge under SFAS 133.


Question 07
In Question 7 and all remaining questions, assume that all ten banks comprise
just one bank called the "New York Bank." This simplifies the accounting. You
may ignore any cash flows owed to the ten banks as separate entities.

In Question 7 and all remaining questions, assume the New York Bank closes its
revenue and expense accounts to Retained Earnings at the end of each month.

For this question, assume there is no $251 million loan to Mexcobre. Instead, you may assume that
the bank has some type of income from Sogem that is paid in cash each month equal to the LME
spot price of copper multiplied by 4,000 tons each month. In other words, pretend for now that the New
York bank can retain all cash flows from its swap contract with Banque Paribus. Assume the New
York bank in this instance chooses to account for the copper swap as a cash flow hedge under SFAS
133 (ignoring any argument that SFAS 133 might not apply). You are to make journal entries for only
the copper price hedge between the New York Bank and Banque Paibus. Ignore the fact that ten banks
are involved and assume all net swap payments flow to or from the New York Bank.

What is the journal entry made by the New York Bank at the date the swap is initiated on January 1,
19x1? What is the entry made on January 31, 19x1 by this bank to record the cash payment from
Sogem in Belgium for 4,000 tons of copper at $1,850 per ton. Limit your answer to the swap
accounting and do not attempt to account for loan of $251 million in this question or the return of any
surplus payments to Mexcobre. Assume that in the first month, the Banque Paribus honors its swap
obligation by sending the New York Bank a check for the net difference between $2,000 per ton versus
the spot price of $1,850 per ton for 4,000 tons of copper. What is the journal entry for the New York
bank to account for the swap payment? What are the journal entries for Banque Paribus at the
inception of the swap on January 1, 19x1 and after the first net swap cash payment on January 31,
19x1?

When applying SFAS 133 rules, use the data shown in the table below:

                              Current      Swap            Net         Journal          Copper            Assumed
                              Copper     Receivable       Price         Entry            Swap              Swap
                    Month     Price/ton        Price      Difference     Date        Cash Flow          Value
                     0                                                  01/01/x1                          $0
                     1         $1,850         $2,000         $150       01/31/x1       $600,000      $16,942,276
                     2         $2,100         $2,000        ($100)      02/28/x1      ($400,000)    ($11,064,274)
                     3         $2,400         $2,000        ($400)      03/31/x1     ($1,600,000)   ($43,320,951)

In Question 7, restrict your entries to cash flows from Sogem and the SFAS 133 entries for the
copper price swap. Entries for the Mexcobre note will be made in a later question.


Please use the following account titles in your journal entries:

          Cash
          Copper price swap receivable/payable
          Interest expense/revenue (this account is not used in Questions 7 and 8)
          Loss/gain on copper price speculation (use this account with all cash flows in Questions 7 and 8).
          Other comprehensive income
          Retained Earnings

The accounting is similar to that in Example 5 of SFAS 133, pp. 72-76, Paragraphs 131-138.

 Date               Question 7 Journal Entries Assuming
 19x1               Surplus Funds Are Not Returned                       Debit          Credit        Balance
Jan. 01 Cash                                                              0               0             $0
                   Copper price swap receivable/payable                   0               0             $0
          -To record the swap with Banque Paribus

Jan. 31 Cash                                                           7,400,000          0          $7,400,000
                  Loss/gain on copper price speculation                    0          7,400,000     ($7,400,000)
          -Copper cash settlement from Sogem in Belgium

Jan. 31 Cash                                                            600,000           0          $8,000,000
                  Loss/gain on copper price speculation                    0           600,000      ($8,000,000)
          -Net swap cash payment from Banque Paribus

Jan. 31 Copper price swap receivable/payable                           16,942,276         0          $16,942,276
                Other comprehensive income                                  0        16,942,276     ($16,942,276)
         -To adjust the swap to fair value

Jan. 31 Loss/gain on copper price speculation                        8,000,000           0               $0
                 Retained earnings                                       0           8,000,000      ($8,000,000)
        To close the expense/revenue accounts




Question 08
Repeat the Question 7 accounting for the February 28 and March 31 net cash flows from both the
Sogem and Banque Paribus contracts. Accumulate the balances for Cash, Other Comprehensive
Income, and Retained Earnings from Question 7. Assume that the LME copper spot prices are
$2,100 for February and $2,400 for March on 4,000 tons of copper each month.

Also draw a graph comparing the monthly increase in cash versus the monthly increase in
retained earnings for January 31, February 28, and March 31.

When making the SFAS 133 journal entries for the swap, use Question 7 table.

At the end of your answers to Question 8, discuss whether this copper price swap was effective in
terms of SFAS 133 criteria for hedge effectiveness. Explain your answer.


 Date              Question 8 Journal Entries Assuming
 19x1              Surplus Funds Are Not Returned                       Debit          Credit         Balance

Feb. 28 Cash                                                         8,400,000           0          $16,400,000
                 Loss/gain on copper price speculation                   0           8,400,000      ($8,400,000)
         -Copper cash settlement from Sogem in Belgium

Feb. 28 Cash                                                             0            400,000       $16,000,000
                 Loss/gain on copper price speculation                400,000            0          ($8,000,000)
         -Net swap cash payment from Banque Paribus

Feb. 28 Copper price swap receivable/payable                              0          28,006,550     ($11,064,274)
                Other comprehensive income                           28,006,550           0          $11,064,274
        -To adjust the swap to fair value

Feb. 28 Loss/gain on copper price speculation                          8,000,000           0             $0
                 Retained earnings                                         0           8,000,000    ($16,000,000)
        To close the expense/revenue accounts




 Date            Question 8 Journal Entries Assuming
 19x1            Surplus Funds Are Not Returned                           Debit          Credit       Balance

Mar. 31 Cash                                                           9,600,000           0        $25,600,000
                Loss/gain on copper price speculation                                  9,600,000    ($9,600,000)
        -Copper cash settlement from Sogem in Belgium

Mar. 31 Cash                                                               0           1,600,000    $24,000,000
                Loss/gain on copper price speculation                  1,600,000           0        ($8,000,000)
        -Net swap cash payment from Banque Paribus

Mar. 31 Copper price swap receivable/payable                                0          32,256,678   ($43,320,951)
                 Other comprehensive income                            32,256,678           0        $43,320,951
        -To adjust the swap to fair value

Mar. 31 Loss/gain on copper price speculation                          8,000,000           0         ($1,600,000)
                 Retained earnings                                         0           8,000,000    ($24,000,000)
        To close the expense/revenue accounts


Change in Balance         Jan. 31        Feb. 28         Mar. 31        Balance
Cash                     $8,000,000    $8,000,000      $8,000,000      $24,000,000
Swap receivable/payable $16,942,276    ($28,006,550)   ($32,256,678)    $43,320,951
Retained earnings       ($8,000,000)    ($8,000,000)    ($8,000,000)   ($24,000,000)




                  Monthly Change in Account Balances Due to Copper Price Swap
                   Monthly Change in Account Balances Due to Copper Price Swap

      $20,000,000
                                              Monthly Increment to Cash
      $10,000,000
               $0                    Monthly Increment to Retained Earnings
     ($10,000,000)              Jan. 31                    Feb. 28                    Mar. 31
     ($20,000,000)                 Monthly Increment to Swap Receivable/Payable
     ($30,000,000)
     ($40,000,000)


In the above resulting accounting balances, we see that there has been no cash flow
hedge ineffectiveness. There cannot be hedge ineffectiveness since the Banque Paribus
paid a fixed $2,000 price per ton of copper to the New York Bank. According to Paragraph
30 on Page 21 of SFAS 133, ineffectiveness is to be defined at the time the hedge is undertaken
the New York Bank gets $8,000,000 per month irrespective of copper price movements.


Question 09
Professor Rashad Abdel-Khalik argues that value at risk (VAR) cannot be computed for the ten banks.
Do you agree? What other SEC alternatives are available for disclosing the risks of the Mexcobre
contracting in this case?

         [Hint: Look under the term "Disclosure" in Bob Jensen's SFAS 133 Glossary.
         Also read the transcript of a presentation by Professor Walter Teets and then read the
         comments by Professor Rashad Abdel-Khalik.]


It appears to me that VAR can be computed easily for this case, because the banks have hedged
away almost all risk except for the unlikely risk of failure of Meccobre to deliver at least 4,000 tons
per month to Mexcobre. The Question 6 answer discusses those unlikely risks.

The SEC allows for tabular disclosures and sensitivity analysis disclosures in place of a value at
risk (VAR) analysis. See the term disclosure in Bob Jensen's SFAS 133 Glossary. Also see the
transcript of the Walter Teets presentation for more details.
Question 10
For this question, assume that the one New York Bank loaned the entire $251 million to Mexcobre.
If you disagree with Professor Rashad Abdel Khalik that SFAS 133 accounting would not apply to
the New York Bank, what accounting would you recommend at the inception of each contract and with
the net swap cash flows mentioned in Question 7 and 8? Unlike in Question 7, assume that surplus
funds from high copper prices are returned monthly to Mexcobre above and beyond the 11.48%
interest rate that equates to 0.95667% per month. Also limit your answer to the contract to loan
$251 million, the contract between the New York Bank and Sogem, the contract with Banque Paribus,
and the return of surplus funds to Mexcobre. Assume that the loan principal is amortized over 38
months much like mortgage note amortization in the calculation of loan payments to the New York
 bank at 0.95667%. In other words, each net swap payment from the Banque Paribus is to be
added to the Sogem payment. At the end of each month, the New York Bank deducts a monthly
loan payment from the fund accumulated variable payments from Sogem and the net swap payments
 from Banque Paribus. Any surplus is then sent to Mexcobre each month.

In summary, you are to make the New York Bank's journal entries for the following:

         1. $251 million loan to Mexcobre on January 1, 19x1;

         2. the Banque Paribus swap contract on January 1, 19x1;

         3. the variable monthly payments from Sogem on January 31, February 28, and March 31
                   assuming 4,000 tons per month at spot prices of $1,850 per ton in January,
                   $2,100 per ton in February, and $2,400 per ton in March;

         4. the monthly net copper swap receipts or payments from Bank Paibus on January 31,
                  February 28, and March 31 on fixed swap receipts of $2,000 per ton and swap
                  payments at the same prices used by Sogem to transmit the payments each month;

         5. the first three loan payments (principal and interest) from the escrow fund to the New
                      York bank on January 31, February 28, and March 31, 19x1;

         6. The three monthly surplus payments to Mexcobre in 19x1.

In addition, you are to prepare the $251 loan amortization schedule across 38 months and show the
interest expense, principal reduction, and total loan payment each month that is deducted from
the cash payments from Sogem and Banque Paribus in each of the 38 months. Discuss why the loan
would probably not be periodically remeasured to market value under SFAS 115 rules. Why might this
not affect having to remeasure the copper price swap to market value on the books of the bank?
(Your instructor may prefer to provide you with this loan amortization schedule so that all students work
with the same schedule.)

When applying SFAS 133 rules, use the data shown in the table below:

                              Current       Swap         Net            Journal         Copper            Assumed
                               Copper     Receivable    Price            Entry           Swap               Swap
                    Month     Price/ton     Price    Difference           Date         Cash Flow            Value
                     0                                                  01/01/x1                              $0
                     1         $1,850       $2,000          $150        01/31/x1         $600,000        $16,942,276
                     2         $2,100       $2,000         ($100)       02/28/x1        ($400,000)      ($11,064,274)
                     3         $2,400       $2,000         ($400)       03/31/x1       ($1,600,000)     ($43,320,951)

Please use the following Chart of Accounts in your journal entries:

                   Cash
                   Copper price swap receivable/payable (actually an optional account)
                   Notes receivable - Mexcobre
                   Interest expense/revenue (this account is not used in Questions 7 and 8)
                   Loss/gain on copper price speculation (use this account only in Questions 7, 8, and 12)
                   Accounts payable - Mexcobre (in Question 10, any surplus funds are sent to Mexcobre monthly)
                   Retained Earnings


Bob Jensen's Answers to Question 10

Go to Sheet 3 to view the $251 loan amortization schedule ---->

 Date            Question 10 Journal Entries Assuming
 19x1            Surplus Funds Are Returned                               Debit          Credit           Balance
Jan. 01 Note receivable - Mexcobre                                     251,000,000          0           $251,000,000
                  Cash                                                      0          251,000,000     ($251,000,000)
        -To record the loan to Mexcobre
Jan. 01 Cash                                               0            0        ($251,000,000)
                Copper price swap receivable/payable       0            0             $0
       -To record the swap with Banque Paribus

Jan. 31 Cash                                           7,400,000         0       ($243,600,000)
               Accounts payable - Mexcobre                 0        $7,400,000    ($7,400,000)
       -Copper cash settlement from Sogem in Belgium

Jan. 31 Cash                                             600000          0       ($243,000,000)
               Accounts payable - Mexcobre                  0         600000      ($8,000,000)
       -Net swap cash payment from Banque Paribus


Jan. 31 Accounts payable - Mexcobre                    8,000,000        0               $0
                 Interest expense/revenue                  0        2,401,233      ($2,401,233)
                 Notes receivable - Mexcobre               0        5,508,432     $245,491,568
                 Cash                                      0          90,334     ($243,090,334)
        -To record cash settlement with Mexcobre

Jan. 31 Copper price swap receivable/payable           16,942,276        0        $16,942,276
                 Other comprehensive income                 0       16,942,276   ($16,942,276)
        -To adjust the swap to fair value

Jan. 31 Interest expense/revenue                       2,401,233        0              $0
                  Retained earnings                        0        2,401,233     ($2,401,233)
        -To close the expense/revenue accounts


Feb. 28 Cash                                           8,400,000        0        ($234,690,334)
               Accounts payable - Mexcobre                 0        8,400,000     ($8,400,000)
       -Copper cash settlement from Sogem in Belgium

Feb. 28 Cash                                               0         400,000     (235,090,334)
               Accounts payable - Mexcobre              400,000         0         (8,000,000)
       -Net swap cash payment from Banque Paribus
Feb. 28 Accounts payable - Mexcobre                     8,000,000        0               0
                 Interest expense/revenue                   0        2,348,536      (2,348,536)
                 Notes receivable - Mexcobre                0        5,561,130     239,930,438
                 Cash                                       0          90,334     (235,180,668)
        -To record cash settlement with Mexcobre

Feb. 28 Copper price swap receivable/payable                 0       28,006,550   ($11,064,274)
                 Other comprehensive income             28,006,550        0        $11,064,274
        -To adjust the swap to fair value

Feb. 28 Interest expense/revenue                        2,348,536        0              0
                  Retained earnings                         0        2,348,536     (4,749,769)
        -To close the expense/revenue accounts


Mar. 31 Cash                                            9,600,000        0        ($225,580,668)
                Accounts payable - Mexcobre                 0        9,600,000     ($9,600,000)
        -Copper cash settlement from Sogem in Belgium

Mar. 31 Cash                                                0        1,600,000    (227,180,668)
                Accounts payable - Mexcobre             1,600,000        0         (8,000,000)
        -Net swap cash payment from Banque Paribus

Mar. 31 Accounts payable - Mexcobre                     8,000,000        0               0
                 Interest expense/revenue                   0        2,295,335      (2,295,335)
                 Notes receivable - Mexcobre                0        5,614,331     234,316,107
                 Cash                                       0          90,334     (227,271,002)
        -To record cash settlement with Mexcobre

Mar. 31 Copper price swap receivable/payable                 0       32,256,678   ($43,320,951)
                 Other comprehensive income             32,256,678        0        $43,320,951
        -To adjust the swap to fair value

Mar. 31 Interest expense/revenue                        2,295,335        0              0
                  Retained earnings                         0        2,295,335     (7,045,104)
        -To close the expense/revenue accounts
Under SFAS 115 rules, the loan would probably be classified by the bank as a security
investment intended to be "held-to-maturity." A deal this complicated would be difficult to
classify as being "available-for-sale." In that case, the note receivable is not remeasured
to market on the balance sheet.

Held-to-maturity securities may not be hedged for cash flow risk according to Paragraphs 426-431
according to Paragraphs 426-431 beginning on Page 190 of SFAS 133. The reason is that
SFAS 133 is intended to hedge price and interest rate risk and not credit risk of loan
default. This is why the deal with Sogem in Belgium could not be accounted for as a cash
flow hedge under Paragraph 29e of SFAS 133. The copper price swap with Banque Paribus,
on the other hand, is not a credit risk swap. It is an independent derivative contract entered
into as a copper price hedge. As such, I feel that it qualifies to be accounted for as a hedge
under SFAS 133 rules.


Question 11
Compute and compare the rate of return to the New York Bank in Question 10 for each of the
first three months. Compare this with the rate of return that would be obtained each month
if the surplus funds were not returned to Mexcobre. In order to simplify the calculation of this rate of
return, compute each month's rate of return as the ratio of that month's net income from the Mexcobre
transactions divided by the beginning balance of the note's principal still outstanding. You are to
compare the solutions with versus without transfer of surplus funds to Mexcobre.

Rate of Return When Surplus Funds Are Returned to Meccobre
          11.48% = fixed rate of return each year in the Sheet 3 Amortization Schedule.
         ####### = fixed rate of return each month in the Sheet 3 Amortization Schedule.



Comment: With the price risk of copper hedged with the Banque Paibus swap, the New York Bank
can never do worse than receive 0.9567% monthly return on the note with Mexcobre. When copper
prices are at or below $2,000 per ton, the return will be 0.9567%. When copper spot prices rise above
$2,000 per ton, the benefit does not accrue to either the New York Bank or Mexicobre. Because copper
price movements are hedged, the surplus funds returned to Mexcobre are $90,334 every month.
Rate of Return When Surplus Funds Are Not Returned to Meccobre

          #######      =    ($8,000,000 - $5,508,432)/$251,000,000 rate of return for January
          #######      =    ($8,000,000 - $5,561,130)/$245,491,568 rate of return for February
          #######      =    ($8,000,000 - $5,614,331)/$239,930,438 rate of return for March

Comment: With the price risk of copper hedged with the Banque Paibus swap, the New York Bank
will always have a higher return if the $90,334 surplus each month is not returned to Mexcobre.
However, the original contract on the note requires that any surplus be returned. Mexcobre had
nothing to say about the copper price swap with Banque Paibus, but that swap affected Mexcobre
by fixing the surplus at $90,334 per month.


Question 12
Repeat the January, February, and March answers for Question 10 assuming that there is no copper
price swap with Banque Paibus. In order to simplify the calculation of the rate of return in Question 12,
compute each month's rate of return as the ratio of that month's net income from the Mexcobre
transactions divided by the beginning balance of the note's principal still outstanding. You are to
compare the solutions with versus without transfer of surplus funds to Mexcobre. In other words, you
must provide two alternative sets of journal entries. Assume that the surplus funds sent each month
are either zero (if the copper price declines below the breakeven point) or positive (equal to the surplus
above the monthly breakeven point)

A major question here is whether to include the increments to Other Comprehensive Income (OCI) in
the numerator of the rate of return calculations when surplus funds are not returned to Mexcobre. For
Question 12, please add OCI increments to the numerator of the rate of return calculations.

Make all journal entries for the contracts with Mexcobre and Sogem. Assume that the note is
maintained under amortized historical cost and is not adjusted for fair market value. Then compare all
your journal entries for Question 12 versus Question 10. Please discuss the impact of the swap on
 the New York Bank.

After you finish the journal entries, compute the breakeven price of copper for which the New York Bank will exactly earn its contracted
will exactly earn its contracted 11.48% per year or 0.9567% per month. Then comment on the impact of varying copper prices when
of varying copper prices when surplus funds above the breakeven copper price are returned versus not returned to Mexcobre.
returned to Mexcobre.
Please use the same account names that are listed in the Chart of Accounts for Question 10.

Bob Jensen's Answers to Question 12 When Surplus Funds Are Returned to Mexcobre

Go to Sheet 3 to view the $251 loan amortization schedule ---->

 Date            Question 12 Journal Entries Assuming
 19x1            Surplus Funds Are Returned                            Debit         Credit         Balance
Jan. 01 Note receivable - Mexcobre                                  251,000,000         0         $251,000,000
                  Cash                                                   0         251,000,000   ($251,000,000)
        -To record the loan to Mexcobre

Jan. 01 No swap to record
                 No swap to record
        -There is no swap with Banque Paribus

Jan. 31 Cash                                                        7,400,000           0        ($243,600,000)
                 Accounts payable - Mexcobre                            0          $7,400,000     ($7,400,000)
         -Copper cash settlement from Sogem in Belgium

Jan. 01 No swap payment to record
                 No swap payment to record
        -There is no swap with Banque Paribus

Jan. 31 Accounts payable - Mexcobre                                 7,400,000           0               $0
                 Interest expense/revenue                               0           2,401,233      ($2,401,233)
                 Notes receivable - Mexcobre                            0           5,508,432     $245,491,568
                 Loss/Gain on copper price speculation               509,666            0           $509,666
                 Cash                                                   0               0        ($243,600,000)
        -To record cash settlement with Mexcobre

Jan. 31 Interest expense/revenue                                    2,401,233           0              $0
                  Loss/Gain on copper price speculation                 0            509,666           $0
                  Retained earnings                                     0           1,891,568     ($1,891,568)
        -To close the expense/revenue accounts
Feb. 28 Cash                                              8,400,000       0       ($235,200,000)
                Accounts payable - Mexcobre                   0       8,400,000    ($8,400,000)
        -Copper cash settlement from Sogem in Belgium

Feb. 28 No swap payment to record
                 No swap payment to record
        -There is no swap with Banque Paribus

Feb. 28 Accounts payable - Mexcobre                       8,400,000       0             $0
                 Interest expense/revenue                     0       2,348,536     (2,348,536)
                 Notes receivable - Mexcobre                  0       5,561,130    239,930,438
                 Loss/Gain on copper price speculation        0           0             $0
                 Cash                                         0        490,334    (244,090,334)
        -To record cash settlement with Mexcobre

Feb. 28 Interest expense/revenue                          2,348,536        0            0
                  Loss/Gain on copper price speculation       0           $0           $0
                  Retained earnings                           0       2,348,536    (4,240,104)
        -To close the expense/revenue accounts


Mar. 31 Cash                                              9,600,000       0       ($234,490,334)
                Accounts payable - Mexcobre                   0       9,600,000    ($9,600,000)
        -Copper cash settlement from Sogem in Belgium

Mar. 31 No swap payment to record
                 No swap payment to record
        -There is no swap with Banque Paribus

Mar. 31 Accounts payable - Mexcobre                       9,600,000       0             $0
                 Interest expense/revenue                     0       2,348,536     (2,348,536)
                 Notes receivable - Mexcobre                  0       5,561,130    234,369,308
                 Loss/Gain on copper price speculation        0           0             $0
                 Cash                                         0       1,690,334   (245,780,668)
        -To record cash settlement with Mexcobre

Mar. 31 Interest expense/revenue                          2,348,536      0              0
                  Loss/Gain on copper price speculation               0              $0                 $0
                  Retained earnings                                   0          2,348,536          (6,588,640)
         -To close the expense/revenue accounts



Main conclusions given the note amortization schedule in Sheet 3:

To obtain the contracted return of 11.48% per year, the New York Bank must receive exactly
$7,909,666 according to the loan amortization schedule in Sheet 3. Hence the break even
copper price is $7,909,666/4000 = $1,977.42 per ton.

If there are no copper price hedge and no surplus funds vis-à-vis the loan amortization, the
New York Bank stands to lose on copper prices below $1,977.42 per ton but can never gain
on copper prices above $1,977.42 per ton since all surplus funds are returned to Mexcobre.

The Bank had a copper price speculation loss in January since the $1,850 copper price fell
below the $1,977.42 breakeven price per ton.

Copper prices in February and March exceeded the $1977.42 breakeven point, but all gains
above the breakeven point were transferred out to Mexcobre.

If surplus funds are returned to Mexcobre, the copper prices of $2,100 in February and $2,400
in March do not benefit the New York Bank. Hence it is pretty obvious that the copper price
swap with Banque Paibus is a no-brainer decision for the New York Bank. For virtually no cost
to enter into the swap, the bank protects itself from copper price drops below $1,977.42 per ton.



Bob Jensen's Answers to Question 12 When Surplus Funds Are Not Returned to Mexcobre

Go to Sheet 3 to view the $251 loan amortization schedule ---->

 Date            Question 12 Journal Entries Assuming
 19x1            Surplus Funds Are Not Returned                      Debit        Credit          Balance
Jan. 01 Note receivable - Mexcobre                                251,000,000        0          $251,000,000
                  Cash                                                 0        251,000,000    ($251,000,000)
        -To record the loan to Mexcobre
Jan. 01 No swap to record
                 No swap to record
        -There is no swap with Banque Paribus

Jan. 31 Cash                                              7,400,000        0       ($243,600,000)
                Accounts payable - Mexcobre                   0       $7,400,000    ($7,400,000)
        -Copper cash settlement from Sogem in Belgium

Jan. 01 No swap payment to record
                 No swap payment to record
        -There is no swap with Banque Paribus

Jan. 31 Accounts payable - Mexcobre                       7,400,000       0               $0
                 Interest expense/revenue                     0       2,401,233      ($2,401,233)
                 Notes receivable - Mexcobre                  0       5,508,432     $245,491,568
                 Loss/Gain on copper price speculation     509,666        0           $509,666
                 Cash                                         0           0        ($243,600,000)
        -To record cash settlement with Mexcobre

Jan. 31 Interest expense/revenue                          2,401,233       0              $0
                  Loss/Gain on copper price speculation       0       $509,666           $0
                  Retained earnings                           0       1,891,568     ($1,891,568)
        -To close the expense/revenue accounts


Feb. 28 Cash                                              8,400,000       0        ($235,200,000)
                Accounts payable - Mexcobre                   0       8,400,000     ($8,400,000)
        -Copper cash settlement from Sogem in Belgium

Feb. 28 No swap payment to record
                 No swap payment to record
        -There is no swap with Banque Paribus

Feb. 28 Accounts payable - Mexcobre                       8,400,000       0             $0
                Interest expense/revenue                      0       2,348,536     (2,348,536)
                Notes receivable - Mexcobre                   0       5,561,130    239,930,438
                 Loss/Gain on copper price speculation              0          490,334         (490,334)
                 Cash                                               0             0          (235,200,000)
        -To record cash settlement with Mexcobre

Feb. 28 Interest expense/revenue                                2,348,536         0                0
                  Loss/Gain on copper price speculation         $490,334          0               $0
                  Retained earnings                                 0         2,838,870       (4,730,438)
        -To close the expense/revenue accounts


Mar. 31 Cash                                                    9,600,000         0          ($225,600,000)
                Accounts payable - Mexcobre                         0         9,600,000       ($9,600,000)
        -Copper cash settlement from Sogem in Belgium

Mar. 31 No swap payment to record
                 No swap payment to record
        -There is no swap with Banque Paribus

Mar. 31 Accounts payable - Mexcobre                             9,600,000         0                $0
                 Interest expense/revenue                           0         2,348,536        (2,348,536)
                 Notes receivable - Mexcobre                        0         5,561,130       234,369,308
                 Loss/Gain on copper price speculation              0         1,690,334       ($1,690,334)
                 Cash                                               0             0          (236,890,334)
        -To record cash settlement with Mexcobre

Mar. 31 Interest expense/revenue                                2,348,536         0                0
                  Loss/Gain on copper price speculation        $1,690,334         0               $0
                  Retained earnings                                 0         4,038,870       (8,769,308)
        -To close the expense/revenue accounts



Main conclusions given the note amortization schedule in Sheet 3:

To obtain the contracted return of 11.48% per year, the New York Bank must receive exactly
$7,909,666 according to the loan amortization schedule in Sheet 3. Hence the break even
copper price is $7,909,666/4000 = $1,977.42 per ton.
If there is no copper price hedge and no surplus fund returns to Mexcobre, the New York
will lose if copper prices fall below $1,977.42 and gain if they rise above $1,977.42.

The bank had a copper price speculation loss in January since the $1,850 copper price fell
below the $1,977.42 breakeven price per ton.

In February and March it had relatively large copper price speculation gains from the
high $2,100 and $2,400 prices per ton of copper at the LME spot prices.

If surplus funds are returned to Mexcobre, the copper prices of $2,100 in February and $2,400
in March do benefit the New York Bank. However, if surplus funds are not returned, the New
York bank now has a tough decision to make about whether it wants to speculate in copper
price movements. In most instances, banks prefer to avoid such speculations. However,
banks do not always avoid price speculations on such deals.

As mentioned previously, however, the contract called for return of surplus funds to
Mexcobre. Hence, the decision to hedge copper price movements that could never benefit
the New York Bank is a no-brainer for that bank.


Question 13
From an accounting theory standpoint, do you think SFAS 133 accounting for the Mexcobre
transactions would help investors more easily analyze the risk management practices of the
New York bank? (One bank was assumed in Questions 7-12 in order to simplify prorationing
of the returns among the ten banks actually involved in the transaction.)

If either the Sogem or the Banque Paribus contracts are booked and adjusted to fair value (no
matter what the rules are under SFAS 133 or IAS 39), do you think that adjusting to fair value
will help or hinder investor analysis of the New York bank?

When answering this question first present arguments on both sides of each issue. Then reason
out your own conclusions.

In Paragraph 220 on Page 123 of SFAS 133, the FASB asserts that "fair value is the most
relevant measure for financial instruments and the only relevant measure for derivative
instruments." In that same paragraph, the FASB claims "derivative instruments should be
measured at fair value, and adjustments in carrying amounts of hedged items should
reflect changes in their fair value (that is, gains or losses) that are attributable to the risk
being hedged . . ."

The analysis above for the Mexcobre Case vividly illustrates how not entering into a copper
price swap would be totally stupid since the New York Bank(s) would only be exposed to losses
due to copper price declines below $1,977.42 and would transfer all gains above that
breakeven point to Mexicobre. Hence, the bank(s) did the entirely correct thing by entering
into a copper price swap with Banque Paibus.

In my viewpoint, the Mexcobre Case is a real world example of where SFAS 133 booking
of the swap at fair value and adjusting that fair value each month is more misleading than
helpful in this instance. I think there are many instances where following SFAS 133 rules
leads to better accounting of derivative instruments. The Mexcobre Case, however,
supports the arguments of bankers that applying SFAS 133 is not only difficult, it can be
very misleading to investors when there is almost zero probability that the derivative instrument
(a price swap in this case) will be held to the maturity. Maturity in this case is assumed to
be the same maturity date as the date of maturity on the loan to Mexcobre.

The major problem is that SFAS 133 and its related 107 and 115 provide virtually no guidance
for measuring fair value of contracts that are not traded in active markets or are traded in
"thin" markets where a sparse number of transactions make market values unreliable as
estimates of fair value. Like interest rate swaps and most other types of swaps, the swap
contract with Banque Paibus is a custom-designed swap that is not traded in any market. There
were no similar contracts for 4,000 tons of copper per month across a 38 month horizon.

The swap value estimates in Question 7, 10, and 12 are hypothetical and would be extremely
difficult to estimate in the real world. Furthermore, the copper price movements around
the $1,977.42 breakeven price create flip flops in disclosing the swap as a large receivable
versus a large payable. For example, in January the copper swap is a large payable but
becomes a large receivable in February and March. When prices decline below $1,977.42
it will flip flop back to a payable.

What is bad for investors is that the flip flopping from being a receivable versus a payable is
a signal that the bank(s) may be doing some type of speculating. In the Mexcobre Case, this
could not be further from the truth. The bank(s) merely entered into a perfectly rational
and stable price swap in order to prevent speculation losses and lock in a fixed return of
11.48% per year on the loan to Mexcobre. It would be irrational to terminate the swap
before the loan terminates. Hence, the swap is not a trading item and reporting huge flip
flops in value can only be misleading.

In support of the bankers opposed to SFAS 133, reporting the changes in value as current
earnings would be totally misleading in the Mexcobre Case. Disclosing these changes in
OCI instead of earnings mitigates this problem, although I have to agree with Professor
Rashad Abdel-Khalik that the OCI is merely a "garbage can" in this particular example if
SFAS 133 rules are applied. An example of this same flip flop problem can be found in
the FASB's own Example 5 beginning at Paragraph 5 on Page 72 of SFAS 133.

As indicated above, I support the SFAS 133 rules for many types of derivative financial
instruments. However, the Mexcobre Case illustrates a real-world set of contracts for which
SFAS 133 rules are dysfunctional. What is more upsetting is that standard setters around the
world, including the International Accounting Standards Committee (IASC), are moving toward
fair value accounting of all financial instruments with the corresponding changes in value
being reported in (highly fluctuating) current earnings even for contracts such as the
Banque Paibus copper price swap where there is no intention to terminate the swap until
the Mexcobre loan terminates. Fluctuations in earning due to fluctuations in value of such
financial instruments creates a misleading instability in both income statements and balance
sheets. Reporting value changes in OCI is only viewed as a temporary compromise with
bankers until the standard setters eventually impose full value accounting in the extreme.

At the time of this writing, it might be noted that the International Accounting Standards
Committee (IASC) has its IAS 39 version of SFAS 133. IAS 39 allows designation
of derivatives as trading versus nontrading for purposes of fair value measurement. The
SFAS 133 does not allow such a distinction such that IAS 39 leads to better accounting
for the Mexcobre case in my option if the swap is designated as nontrading under IAS 39.


The December 1998 issue of the Journal of Accountancy provides an interesting contrast
on fair value accounting. On Pages 12-13 you will find a speech by SEC Chairman Arthur
Levitt bemoaning the increasingly common practice of auditors to allow earnings
management. On Page 20 you will find a review of an Eight Circuit Court of Appeals
case in which a firm prevented the reporting of net losses for 1988 and 1989 by persuading
 its auditor to allow reclassification of a large a large hotel as being "for sale" so that
it could revalue historical cost book value to current exit value and record the gain as
current income. Back issues of the Journal of Accountancy are now online at
http://www.aicpa.org/pubs/jofa/joaiss.htm




Case Questions and Bob Jensen's Answers
Mexcobre Case
Using Swaps to Increase Debt: The Real World Case of a Copper Swap
Bob Jensen at Trinity University                                                  http://www.trinity.edu/~rjensen
The HTML version of this case can be found at
                         http://www.trinity.edu/~rjensen/acct5341/speakers/133spraos.htm




Case Questions and Bob Jensen's Answers
PV=$251,000,000               $251,000,000          $251,000,000   $251,000,000     $251,000,000
R=.1148/12 per month             0.9567%              0.9567%        0.9567%          0.9567%
N=38 months                         38                   38             38               38
               Period =              0                    1              2                3
    IPMT Formula               Interest Revenue = $2,401,233        $2,348,536       $2,295,335
    PPMT Formula            Principal Reduction = $5,508,432        $5,561,130       $5,614,331
     PMT Formula        Monthly Loan Payment =       $7,909,666     $7,909,666       $7,909,666
    Computation Check        Interest + Principal = $7,909,666      $7,909,666       $7,909,666
        Net cash from Sogem and Bank Paribus = $8,000,000           $8,000,000       $8,000,000
                      Amount owed to Mexcobre =       $90,334        $90,334          $90,334




                        Mexcobre $251 Million Loan Amortization
        $10,000,000
                                             Monthly Total Payment
         $8,000,000
         $6,000,000                                Monthly Reduction in Principal
         $4,000,000
                                                Monthly Reduction Interest Expanse
         $2,000,000
                 $0
       Month of Payment
                            1    4    7 10 13 16 19 22 25 28 31 34 37
p://www.trinity.edu/~rjensen




             $251,000,000      $251,000,000   $251,000,000   $251,000,000   $251,000,000   $251,000,000
               0.9567%           0.9567%        0.9567%        0.9567%        0.9567%        0.9567%
                  38                38             38             38             38             38
                   4                 5              6              7              8              9
              $2,241,624        $2,187,400     $2,132,657     $2,077,390     $2,021,595     $1,965,265
              $5,668,042        $5,722,266     $5,777,009     $5,832,276     $5,888,071     $5,944,400
              $7,909,666        $7,909,666     $7,909,666     $7,909,666     $7,909,666     $7,909,666
              $7,909,666        $7,909,666     $7,909,666     $7,909,666     $7,909,666     $7,909,666
              $8,000,000        $8,000,000     $8,000,000     $8,000,000     $8,000,000     $8,000,000
               $90,334           $90,334        $90,334        $90,334        $90,334        $90,334
$251,000,000   $251,000,000   $251,000,000   $251,000,000   $251,000,000   $251,000,000
  0.9567%        0.9567%        0.9567%        0.9567%        0.9567%        0.9567%
     38             38             38             38             38             38
     10             11             12             13             14             15
 $1,908,397     $1,850,985     $1,793,024     $1,734,508     $1,675,432     $1,615,791
 $6,001,268     $6,058,680     $6,116,642     $6,175,158     $6,234,233     $6,293,874
 $7,909,666     $7,909,666     $7,909,666     $7,909,666     $7,909,666     $7,909,666
 $7,909,666     $7,909,666     $7,909,666     $7,909,666     $7,909,666     $7,909,666
 $8,000,000     $8,000,000     $8,000,000     $8,000,000     $8,000,000     $8,000,000
  $90,334        $90,334        $90,334        $90,334        $90,334        $90,334
$251,000,000   $251,000,000   $251,000,000   $251,000,000   $251,000,000   $251,000,000
  0.9567%        0.9567%        0.9567%        0.9567%        0.9567%        0.9567%
     38             38             38             38             38             38
     16             17             18             19             20             21
 $1,555,580     $1,494,793     $1,433,424     $1,371,468     $1,308,919     $1,245,772
 $6,354,086     $6,414,873     $6,476,242     $6,538,198     $6,600,747     $6,663,894
 $7,909,666     $7,909,666     $7,909,666     $7,909,666     $7,909,666     $7,909,666
 $7,909,666     $7,909,666     $7,909,666     $7,909,666     $7,909,666     $7,909,666
 $8,000,000     $8,000,000     $8,000,000     $8,000,000     $8,000,000     $8,000,000
  $90,334        $90,334        $90,334        $90,334        $90,334        $90,334
$251,000,000   $251,000,000   $251,000,000   $251,000,000   $251,000,000   $251,000,000
  0.9567%        0.9567%        0.9567%         0.9567%        0.9567%        0.9567%
     38             38             38              38             38             38
     22             23             24              25             26             27
 $1,182,020     $1,117,659     $1,052,682      $987,084       $920,858       $853,998
 $6,727,645     $6,792,006     $6,856,983     $6,922,582     $6,988,808     $7,055,667
 $7,909,666     $7,909,666     $7,909,666     $7,909,666     $7,909,666     $7,909,666
 $7,909,666     $7,909,666     $7,909,666     $7,909,666     $7,909,666     $7,909,666
 $8,000,000     $8,000,000     $8,000,000     $8,000,000     $8,000,000     $8,000,000
  $90,334        $90,334        $90,334         $90,334        $90,334        $90,334
$251,000,000   $251,000,000   $251,000,000   $251,000,000   $251,000,000   $251,000,000
   0.9567%        0.9567%        0.9567%        0.9567%        0.9567%        0.9567%
      38             38             38             38             38             38
      28             29             30             31             32             33
  $786,499       $718,354       $649,557       $580,102       $509,983       $439,193
 $7,123,167     $7,191,311     $7,260,108     $7,329,563     $7,399,683     $7,470,473
 $7,909,666     $7,909,666     $7,909,666     $7,909,666     $7,909,666     $7,909,666
 $7,909,666     $7,909,666     $7,909,666     $7,909,666     $7,909,666     $7,909,666
 $8,000,000     $8,000,000     $8,000,000     $8,000,000     $8,000,000     $8,000,000
   $90,334        $90,334        $90,334        $90,334        $90,334        $90,334
$251,000,000   $251,000,000   $251,000,000   $251,000,000   $251,000,000
   0.9567%        0.9567%        0.9567%        0.9567%       0.9567%
      38             38             38             38            38
      34             35             36             37            38
  $367,725       $295,574       $222,732       $149,194       $74,952
 $7,541,941     $7,614,092     $7,686,933     $7,760,472     $7,834,714
 $7,909,666     $7,909,666     $7,909,666     $7,909,666     $7,909,666
 $7,909,666     $7,909,666     $7,909,666     $7,909,666     $7,909,666
 $8,000,000     $8,000,000     $8,000,000     $8,000,000     $8,000,000
   $90,334        $90,334        $90,334        $90,334       $90,334

				
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