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					                      CASE 5
         Cash Flow Hedge of Variable-Rate Debt
  •   On 1/1/X1, XYZ, a ‘B’ rated entity, issued a $100
      million note at LIBOR, semiannual payments and
      semiannual variable-rate reset dates, noncallable, 5-
      year term
  •   Current LIBOR is 5.7%
  •   XYZ wants to lock in a 6% fixed rate; XYZ enters
      into an interest-rate swap to pay 6% fixed and
      receive LIBOR
  •   Swap terms include a $100 million notional principal,
      a 5-year term, and semiannual variable-rate reset
  •   At hedge inception, the fair value of the swap is zero
4-1
                   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

                                                 6/30/X1      12/31/X1
Variable-rate debt                          100,000,000    100,000,000
Variable rate                                      5.7%          6.7%*
Semiannual debt payment                        2,850,000      3,350,000
Swap receive variable                        (2,850,000)    (3,350,000)
Swap fixed payment                             3,000,000      3,000,000
Net debt and swap
 interest expense                              3,000,000     3,000,000

*Rate increased 100 basis points on 7/1/X1 reset.

4-3
                        CASE 5
           Cash Flow Hedge of Variable-Rate Debt

                               6/30/X1        12/31/X1


      Fair value of pay
      6% swap                    3,804,0001      3,437,0002


      1
          PV of nine $500,000 semiannual payments,
          discounted at 3.5% per period
      2
          PV of eight $500,000 semiannual payments,
          discounted at 3.5% per period

4-4
                       CASE 5
          Cash Flow Hedge of Variable-Rate Debt
      At 6/30/X1
      Interest expense                2,850,000
              Interest payable                           2,850,000
      To record debt interest accrual
      Interest receivable            2,850,000
      Interest expense                 150,000
              Interest payable                            3,000,000
      To record swap accrual (receive 5.7% and pay-fixed 6%)
      Swap asset                     3,804,000
             OCI                                         3,804,000
      To record fair value of swap excluding accrual

4-5
                        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                  3,350,000
     Interest payable                                     3,350,000
  To record debt interest accrual ((.067 × $100m)/2)

  Interest receivable               3,350,000
         Interest payable                                 3,000,000
     Interest expense                                       350,000
  To record swap accrual (receive 6.7% and pay 6%)

  OCI                                 367,000
          Swap asset                                       367,000
  To record fair value change of swap excluding accrual
4-7
                   CASE 5
      Cash Flow Hedge of Variable-Rate Debt
      •   XYZ documented that the swap and variable-
          rate debt terms for the nominal amounts,
          payment frequency, reset dates, and maturity
          match
      •   The effectiveness of the hedge was
          demonstrated throughout the term of the
          hedge
      •   This hedge is not exposed to basis risk because
          the swap and debt each have the identical
          variable rate (LIBOR)

4-8
                         CASE 6
            Fair Value Hedge of Fixed Rate Debt
                    Long-Haul Method
 •    On 4/3/00, GlobalTechCoSub issues at par a non-callable,
      5-year, $100 million note at 8% fixed interest, semiannual
      payments (debt is rated A1)
 •    On 4/3/00, GlobalTechCo also enters into a 5-year interest
      rate swap; $101,970,000 notional amount, pay LIBOR
      plus 78.5 basis points, receive fixed at 8%, semiannual
      settlement and interest reset dates
 •    Net interest outflow: LIBOR plus 78.5 bps
      (current LIBOR at 6.29%)
 •    Swap is at-market, therefore, no premium required

4-9
                       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                          $4,252,000
 Less:
 Swap accrual for the period 4/3-6/30                236,000

 Net Swap Loss                                   $4,016,000

 (Interest rate shift assumed to be a parallel shift in the yield curve)


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                    3,775,620
Cr        Earnings                            3,775,620

Dr         Earnings             4,016,000
Cr           Swap Liability                   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