Intermediate Accounting
9th Edition
ISBN: 9781259722660
Author: J. David Spiceland, Mark W. Nelson, Wayne M Thomas
Publisher: McGraw-Hill Education
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Textbook Question
Chapter A, Problem 2P
Derivatives; interest rate swap; comprehensive
CMOS Chips is hedging a 20-year, $10 million, 7% bond payable with a 20-year interest rate swap and has designated the swap as a fair value hedge. The agreement called for CMOS to receive payment based on a 7% fixed interest rate on a notional amount of $10 million and to pay interest based on a floating interest rate tied to LIBOR. The contract calls for cash settlement of the net interest amount on December 31 of each year.
At December 31, 2018, the fair value of the derivative and of the hedged bonds has increased by $100,000 because interest rates declined during the reporting period.
Required:
- 1. Does CMOS have an unrealized gain or loss on the derivative for the period? On the bonds? Will earnings increase or decrease due to the hedging arrangement? Why?
- 2. Suppose interest rates increased, rather than decreased, causing the fair value of both the derivative and of the hedged bonds to decrease by $100,000. Would CMOS have an unrealized gain or loss on the derivative for the period? On the bonds? Would earnings increase or decrease due to the hedging arrangement? Why?
- 3. Suppose the fair
value of the bonds at December 31, 2018, had increased by $110,000 rather than $100,000, with the additional increase in fair value due to investors’ perceptions that the creditworthiness of CMOS was improving. Would CMOS have an unrealized gain or loss on the derivative for the period? On the bonds? Would earnings increase or decrease due to the hedging arrangement? Why? - 4. Suppose the notional amount of the swap had been $12 million, rather than the $10 million principal amount of the bonds. As a result, at December 31, 2018, the swap’s fair value had increased by $120,000 rather than $100,000. Would CMOS have an unrealized gain or loss on the derivative for the period? On the bonds? Would earnings increase or decrease due to the hedging arrangement? Why?
- 5. Suppose BIOS Corporation is an investor, having purchased all $10 million of the bonds issued by CMOS as described in the original situation above. BIOS is hedging its investment, classified as available-for-sale, with a 20- year interest rate swap and has designated the swap as a fair value hedge. The agreement called for BIOS to make payment based on a 7% fixed interest rate on a notional amount of $10 million and to receive interest based on a floating interest rate tied to LIBOR. Would BIOS have an unrealized gain or loss on the derivative for the period due to interest rates having declined? On the bonds? Would earnings increase or decrease due to the hedging arrangement? Why?
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QUESTION 3
a. The market values of liabilities and assets are RM115 and RM125,
respectively for OFFSHORE bank. The average duration of this bank's
assets is 1.55, whereas liability's duration is 0.90. Calculate the
duration gap for OFFSHORE bank.
b. Based on the calculation of duration gap in the previous questions
(i.e., a), what is the change in the market value of net worth as a
percentage of assets if interest rates rise from 9% to 11%.
c. If DEFI involves in interest-rate forward contracts with GUMTREE,
how do you complete this contract to hedge interest rate risk? The value
of the contract is RM2 million in face value and offers 4.5% coupon
rate. The treasury bond (i.e. financial instrument) has maturity until
2035.
Compare the required credit risk capital under Basel I and Basel Il for the following set of arrangements.
(a) A 2 year interest rate swap with a principal of $100 million traded with an AA rated company, currently worth 2.5 million
(b) $30 million 3 year Treasury bond with a BBB rated OECD sovereign
(c) $20 million claims secured by residential mortgages
(d) A six month corporate loan of $ 25million to an A+ rated company
Incredible Inc., a manufacturer of children’s toys, enters into a two-year plain vanilla interest rate swap, in which the corporation will receive a fixed rate and pay a floating rate of LIBOR. The notional amount on this swap is $75 million. Swap payments will be netted every 180 days, and the LIBOR requires the assumption of a 360-day year. The term structure of LIBOR on the swap initiation date is as follows:
Days
Rate (%)
180
3.50
360
3.55
540
3.60
720
3.70
a. What is the fixed rate determined on the swap initiation date?
b. Calculate the swap value on the initiation date.
Chapter A Solutions
Intermediate Accounting
Ch. A - Prob. A.1QCh. A - Prob. 2QCh. A - Prob. A.2QCh. A - Prob. 3QCh. A - Prob. A.3QCh. A - Prob. 4QCh. A - Prob. A.4QCh. A - What is the effect on interest of an interest rate...Ch. A - Prob. A.5QCh. A - How are derivatives reported on the balance sheet?...
Ch. A - Prob. A.6QCh. A - When is a gain or a loss from a cash flow hedge...Ch. A - Prob. A.7QCh. A - Prob. 1ECh. A - Prob. A.1ECh. A - Derivatives; interest rate swap; fixed rate debt...Ch. A - Derivatives; interest rate swap; fixed rate...Ch. A - Derivatives; interest rate swap; fixed rate debt;...Ch. A - Prob. 5ECh. A - Derivatives; interest rate swap; fixed-rate debt;...Ch. A - Derivatives; interest rate swap On January 1,...Ch. A - Derivatives; interest rate swap; comprehensive...Ch. A - Derivatives; interest rate swap; fixed rate debt;...Ch. A - Real World Case A1 Derivative losses; recognition...Ch. A - Research Case A4 Issue related to the derivatives...Ch. A - Prob. A.4BYP
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