Hedging

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					Question

On July 1, 20X1, Littleton Inc. loaned a key supplier of raw material $2,000,000 to construct a
new processing facility. The loan is due on July 1, 20X3 and pays interest each December 31 and
June 30. The supplier insisted on a variable rate loan. Charles Upton, controller of Littleton Inc.,
wants to avoid the risk of variable interest rate fluctuations. As a result, Littleton Inc. entered
into an interest rate swap in which it will pay the variable rate on $2,000,000 in exchange for a
fixed interest rate of 8.3%. The swap is settled on the interest payment dates. Variable interest
rates and the value of the swap on selected dates are as follows:

                            Variable Interest Rate     Value of the Swap
          July 1, 20X1                       7.9 %
    December 31, 20X1                        7.75%               $10,400

Prepare all entries to record this hedge through December 31, 20X1.


Solution:

   1) Key supplier A/c………………. $2,000,000

               Cash A/c………………..$2,000,000

       Being cash loaned to supplier to construct a facility for $2,000,000.

   2) When the swap is entered, the market value is given as 0. Thus the firm will make no
       entry. Since the market value is not given, we assume it to be 0, even though the
       variable interest rate is different from the fixed interest rate agreed upon. The value
       could be zero due to the expectations of interest rate movements in the future.

   3) On December 31, 20X1, the journal entry will be as follows:

       Cash A/c…………………………………………. $77,500

       Interest Income A/c……………………...$77,500

       Swap contract A/c………………………………………$10,400

       Accumulated other non comprehensive income $10,400

				
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