Working Paper 286
MarginOOPS Bank Futures: Hedging Strategies and Accounting Under SFAS 133/IAS 39 for Eurodollar Interest Rate Futures to Hedge Profits on Forecasted Loan Transactions
Bob Jensen at Trinity University
Terminology is defined in Bob
Jensens SFAS 133 and IAS 39 Glossary
Case Objectives
The broad objectives of this MarginOOPS Bank Case and its companion MarginWHEW Bank Case are as follows:
To help students learn the complicated ways in which
price quotations on the Eurodollar futures trading markets, as reported in the financial
press, can be translated into alternatives to hedged refundings of outstanding loans.
Examples found in finance textbooks and in the accounting standards pronouncements usually
skip over this complex step in evaluating hedging strategies and accounting outcomes.
To help students learn how to use Eurodollar
interest-rate futures contracts to hedge lending profits. One question in each case
asks students to evaluate the advantages and disadvantages of futures relative to other
hedging alternatives such as interest rate swaps and options contracts.
To illustrate complications caused by having margin
accounts with margin limits in futures contract trading markets. Futures prices are
listed daily on the Chicago Mercantile
Exchange (CME). The MarginWHEW Bank Case is the simpler of the two cases,
because it requires no cash feeds into margin account after a margin account is set in
place. The MarginOOPS Bank Case deals with the more complicated issue of how to
account for subsequent required cash feeds into a margin account when the futures contract
value plunges.
To illustrate how "fixed" effective rates of profit hedges in loan refunding are only approximate rates and explain why convergence is not usually perfect in actuality. Ways of computing expected fixed effective rates are compared for the (91/360 yr) and (364/365) adjustment factors proposed by the CME versus (90/360 yr) and (360/365) factors commonly used by banks.
To help students learn the complicated mechanics of
accounting for Eurodollar interest-rate hedges under SFAS
133 and IAS 39
rules. SFAS 133 is entitled Accounting for Financial Instruments and Hedging Activities
(Norwalk, CT: Financial Accounting Standards Board (FASB), Product Code No. S133, 1998).
Because SFAS 133 is so complex and confusing to corporate and public accountants, its
implementation was postponed in June 1999 for another year. In 1999, the International
Accounting Standards Committee (IASC) issued a similar international standard called IAS
39 entitled Financial Instruments Recognition and Measurement.
To help students learn the complicated mechanics of
calculating current values of futures contract derivative instruments used to hedge cash
flow transactions. Such calculations are important, because they impact upon how
SFAS 133 requires reporting of derivative instruments current values.
Some important points of difference between SFAS 133 in the U.S. and IAS 39 internationally are stressed in this case.
Case Introduction
Note that all terminology definitions are given at
http://WWW.Trinity.edu/rjensen/acct5341/speakers/133glosf.htm#0000Begin
On June 17, 1999 MarginOOPS Bank had forecasted transactions to receive quarterly interest payments on a $25 million, one-year loan at a fixed rate of 8.00% APR. The Treasurer of MarginOOPS Bank, Phil Johnson, worried about rising interest rates on the cost of MarginOOPS Bank funds over the next year.. Signs pointed to rising prices that might lead to upward movements in borrowing costs worldwide. During the next year, LIBOR might well rise substantially, thereby, increasing the quarterly refunding cost of capital used to carry the 8.00% fixed-rate loan. The MarginOOPS Bank would like to lock in the gross profit on the loan's four quarterly payments due on the 17th day of each of the months of September 1999, December 1999, March 2000, and June 2000..
The cost of a futures contract in a trading market such as the Chicago Mercantile Exchange (CME) is called the "settlement price" corresponding to a settlement "yield." The "underlying" of an interest rate futures contract is usually some type of note having a principal amount referred to as the "notional." Futures contracts give holders the option to purchase or sell notes at contracted settlement prices that translate into settlement yields for notes. Futures contracts give holders the option to sell buy notes at contracted settlement prices that translate into settlement gains and losses.
Always remember that as interest rates go up, underlying note prices fall in trading markets and vice versa. Interest rate futures contracts can be used to lock in (approximately) borrowing or lending rates. An advantage of futures contracts vis-a-vis interest rate option contracts is that the initial acquisition cost of a futures purchase or sales contract is virtually zero (i.e., there is no initial premium). A huge disadvantage is that the financial risk is uncertain and possibly unbounded, whereas the most an option holder can lose is the initial premium paid for the contract. Option holders do not incur a penalty if options are never exercised. Futures contracts must be settled in every instance by either a netting out in cash or physical taking/delivery of the underlying notes.
Holders of interest rate sell-then-buy futures (STB) contracts gain from plunging interest rates in the future, whereas holders of buy-then-sell (BTS) contracts gain from soaring interest rates. Interest-rate futures are traded on in organized markets such as the Chicago Mercantile Exchange (CME), Chicago Board of Trade (CBOT), Tokyo Stock Exchange, and others. If an investor sells something "short" on June 17 for $12 and buys it on September 17 for current spot price of $10, the net gain is $2. This type of thing would happen in interest rate STB futures if interest rates rose between June 17 and September 17. Rising interest rates send the market prices of the underlying notes plunging so that they are cheaper to buy in the future. At a certain point, the STB futures contract holder can purchase notes at low spot prices and deliver these notes under the futures sales contract at higher contracted settlement prices (having lower interest rates). Many investors acquire interest rate futures contracts in pure speculation that interest rates are going to go change (thereby creating futures contract gains or losses from changing prices of underlying notes). But instead of speculating, money borrowers may hedge against changing interest rates up or down by locking in a borrowing rate equal to the settlement rate (yield) at the date the futures contracts are acquired in advance of the loan transaction. Common underlyings for interest-rate futures contracts are U.S. Treasury bonds, Eurodollars, Japanese government bonds, and Euroyen.
Eurodollar notes should not be confused with the new Euro currency. Eurodollar notes are virtually risk-free obligations of U.S. Banks that carry contracted interest rates based upon LIBOR. Eurodollars are time deposits in commercial banks outside the United States. Most are in Europe, but they are not confined to Europe. The CME offers Eurodollar time deposit futures contracts. For a $1 million notional, the annualized tick is equivalent, therefore, to $100 = ($1,000,000)(0.01%) = $10,000. The 0.01%, however, is an annual percentage price (APR). The Eurodollar notes on the CME are 90-day notes, such that futures contract prices are based upon the 90-day portions of 0.01%. These portions are expressed as ($100)(3/12 yr) = $25 per tick. For example, a December 1999 futures contract having a listed settlement of 94.21 will have a discounted price of $985,525 = (100% - 94.21%)($1,000,000)(3/12 yr). On the CME, Eurodollar futures use the $25 tick illustrated in a somewhat more revealing way as shown below:
$100 = ($1,000,000)(0.01% per tick ) for a 12-month time span
$ 25 = ($1,000,000)(0.01% per tick )(3/12 yr) for a 3-month time span
5.79% = 100% - 94.21% yield on June 17, 1999 for a
December 1999 futures contract on the CME
579 ticks = 10,000 basis points - 9,421 basis points
$985,525 = $1,000,000 notional - ($25)(579 ticks)
= $1,000,000 notional - ($2500)(5.79 listed yield of the STB
futures contract)
= $1,000,000 notional - ($250,000)(5.79%)
= $1,000,000 notional - ($14,475 discount)
This $985,525 "settlement price" is an artificial selling price against which the eventual artificial purchase "settlement price" is subtracted at the day the sell-then-buy (STB) futures contracts are settled. The net difference is added or subtracted each quarter to the customer's margin balance. In the futures market this is termed "marking-to-market." The customer may draw out the surplus above the margin limit. However, if marking-to-market depletes the balance below the margin limit, the customer must put more funds into the margin account. Therein lies the risk of futures trading vis-a-vis options trading.
The yield can be calculated as follows:
$14,475 = $1,000,000 - $986,400 discount of a June 17, 1999 for a December 1999 futures contract
1.4475% = ($14,475 discount) / ($1,000,000 notional) yield for (3/12 yr)
5.7900% APR = (1.4475%)(4 quarters of the year) yield for a full year
Eurodollar interest-price futures are somewhat different since they are settled net for cash daily without physical delivery of the underlying notes themselves. There is virtually no cost to purchase a futures contract, but the trading exchanges require investors to maintain a deposit called a "margin" such as a $500 minimum margin. Daily gains are credited to the investor's account, and daily losses are charged to it. If the margin falls below the minimum threshold, the investor has to deposit more funds.
Eurodollar futures are traded in the International Money Market (IMM) of the CME. This MarginOOPS Bank case focuses on sell-then-buy (STB) futures contracts to be used by MarginOOPS Bank to hedge a forecasted transaction to borrow $25 million. Phil Johnson decided on a June 17 to purchase 25 sell-then-buy (STB) futures contracts on each of four quarters at the futures prices taken from the Wall Street Journal on June 17. These prices are shown in Exhibit 1.
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If LIBOR rates soar, the STB futures contracts have plunging purchase prices (and soaring gains) that can be settled in the contract periods for cash. In theory, MarginOOPS Bank has "more or less" locked-in a fixed cost of MarginOOPS Bank borrowing rate that is the net rate between the eventual higher borrowing rates minus the gain rate on the hedging contracts. What really happens is that the net settlement of each futures contract hedge will approximately offset the increased or decreased cost of MarginOOPS Bank rates on $25 million for one year on a quarterly basis. Thus, there is a fixed rate of return on the 8% loan of $25 million having interest received quarterly by MarginOOPS Bank.
On June 17, MarginOOPS Bank loaned $25 million at a fixed rate of 8.00% payable at
2.00% quarterly. MarginOOPS funded its loan for the first three months at an
annualized rate of 5.44% APR. It intends to refund each quarter. Phil Johnson
worried that interest rate increases on the quarterly refunding may degrade the profit on
the $25 million fixed-rate loan. On June 17, Phil Johnson acquired Eurodollar STB
futures contracts for December 1999 (25 contracts), March 2000 (25 contracts), and
June 2000 (25 contracts) in order to fix the rate of MarginOOPS Bank profit on the
one-year firmly committed $25 million loan. The futures contract prices are
reproduced in Exhibit 1.
Case Questions (in black)
With Answers (in red)
(Students fill in the answers shown here in red.)
Date | Settlement Price Expressed as an APR % |
Yield Shown In Exhibit 1 |
Settlement Total for |
June 1999 Settlement |
Purchase Date |
5.44% APR |
Acquisition Date |
Dec. 1999 Settlement |
94.21% APR |
5.79% APR |
$24,638,125 |
Mar. 2000 Settlement |
94.13% APR |
5.87% APR |
$24,633,125 |
June 2000 Settlement |
93.92% APR |
6.08% APR |
$24,620,000 |
Assume $25 per tick settlement factors that translate into $2,500 adjustment factors illustrated in the initial part of this case.
Assume all contracts are settled at the dates shown in the first column of the above table.
Assume the Futures Margin Account balance can never fall below a $500 minimum margin balance level.
Assume no interest expense or revenue on the balance left in the Futures Margin Account. This is a simplifying assumption for students dealing with more complex issues in this case.
Although margin accounts are normally settled daily, the settlements in this case will only be on selected dates in order to simplify the illustration.
Fill in all contracted sales amounts (like a short sale for future delivery) shown in the last column of the above table and show how all of the three future contracted settlements are derived. Note that the bank does not actually pay the huge price of 25 contracts. This selling "settlement price" is an artificial selling price against which the eventual artificial purchase "settlement price" is subtracted at the day the sell-then-buy (STB) futures contracts are settled. The net difference is added or subtracted each quarter to the margin balance of MarginOOPS Bank's customer account with the CME.
What are the June 17 "artificial" settlements (in dollars) of all 75 futures contracts?
Hint: The settlement for the first 25 contracts is shown as a guide for students.
$24,638,125 = [$1,000,000 -
($2,500)(5.79)][25 contracts] for 25 December 1999 contracts
$24,633,125 = [$1,000,000 - ($2,500)(5.87)][25 contracts] for 25
March 2000 contracts
$24,620,000 = [$1,000,000 - ($2,500)(6.08)][25 contracts] for 25
June 2000 contracts
What are the actual cash purchase prices of all 75 futures contracts that must be paid by MarginOOPS Bank in cash on June 17, 1999?
$0 purchase amount since there is no premium on futures contracts at the date of acquisition
How much does MarginOOPS Bank have to deposit into the Futures Margin Account on June 17?
$500 is the specified margin limit in the case.
For this part of the case, please adjust yields to quarterly rates using both the (90/360 yr) and (91/360 yr) adjustment factors.
Date | Annual Yield |
Quarterly Yield |
Quarterly Yield |
June 1999 |
5.44% APR |
1.3600% |
1.3751111% |
December 2000 |
5.79% APR |
1.4475% |
1.4635833% |
March 2000 |
5.87% APR |
1.4675% |
1.4838056% |
June 2000 |
6.08% APR |
1.5200% |
1.5368889% |
Date | Annual Yield |
Quarterly
Yield |
Quarterly
Yield |
June 1999 |
5.44% APR |
(5.44%)(3/12 yr) |
(5.44%)(91/360 yr) |
December 1999 |
5.79% APR |
(5.79%)(3/12 yr) |
(5.79%)(91/360 yr) |
March 2000 |
5.87% APR |
(5.87%)(3/12 yr) |
(5.87%)(91/360 yr) |
June 2000 |
6.08% APR |
(6.08%)(3/12 yr) |
(6.08%)(91/360 yr) |
Hint: This calculation for the (91/360 yr) factors is illustrated under the section entitled "How to Get Started Trading CME Interest Rate Products: Section Two: CME Interest Rate Futures," at the CME web site. In particular, try the online "how to" link at http://www.cme.com/market/interest/howto/hedging.html . You can insert the component rates that you derived in Question 3 above.
Warning: The above CME web page has a printing error. The final adjustment factor for the (91/360 yr) components should have been printed in the formula as 364/365 instead of 360/364. Then the CME calculation will yield the approximate 6.11% fixed rate shown at the CME web site.
5.788693% APR = [(1 + 0.01360000)(1 + 0.01475000)(1 + 0.01467500)(1+0.01520000) - 1 ][360/365)]
5.917659% APR = [(1 + 0.01375111)(1 + 0.01463583)(1 + 0.01483806)(1+0.01536889)- 1][364/365]
Your cost of refundings rates computed above translate into what hedged cost of refundings dollars for the entire year from June 17, 1999 to June 17, 2000?
$1,446,734 = (5.78693
%)($25,000,000) hedge cost using (90/360 yr) factorsFrom now on, you may assume the (91/360 yr) quarterly adjustment factor and ignore the (90/360 yr) adjustment factor. The CME prefers the 91/360 adjustment factors.
If the reinvestment opportunity of the interest received on the loan is ignored, we only derive the following:
2.08234% APR = 8.00% note receivable - 5.917659% hedged cost of refundings = hedged profit rate Question 5Question
6A similar problem arises with assumed opportunity values of the cash inflows and outflows from the futures contract hedge. However, these are much smaller in amount than the interest payments on the note receivable. Hence the error is much smaller in terms of total dollar computations of hedging cash returns.
Question 7
- Assume that all cash above the margin limit is retained in the account until a set of futures contracts are settled in cash. The amount of that cash settlement is withdrawn in total provided the funds remaining are greater than or equal to the margin limit that is assumed to be $500 in this case.
- If there is more than $500 in the account but not enough to withdraw an entire settlement, only the amount above $500 is withdrawn. For example, if the settlement is $2,000 when there is only $750 in the account after the settlement, the withdrawal is $250.
- If there is less than $500 in the account at any time, then cash is added to bring the balance up to $500.
- Although increases and decreases in the account take place daily in real life, for purposes of this case, cash flows to and from the account will be assumed to only take place on selected days specified in the case.
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What is the balance sheet asset or liability reported in the financial statements for the Futures Margin Account on August 31, 2000 for all the futures contracts acquired by MarginOOPS Bank on June. 17? First compute the value assuming no margin requirements, and then adjust the account by the amount needed to follow the bank's stipulated margin account policy.
Recall that we earlier computed the following using the June 17 Wall Street Journal settlements shown in Exhibit 1:
5.79% = 100% - 94.21% yield on June 17, 1999 for a
December 1999 futures contract on the CME
579 ticks = 10,000 basis points - 9,421 basis points
$985,525 = $1,000,000 notional
- ($25)(579 ticks)
= $1,000,000 notional - ($2500)(5.79 listed yield of the STB futures
contract)
= $1,000,000 notional -
($250,000)(5.79%)
= $1,000,000 notional - ($14,475 discount)
This $985,525 "settlement price" is an artificial selling price against which the eventual artificial purchase "settlement price" is subtracted at the day the sell-then-buy (STB) futures contracts are settled. The net difference is added or subtracted each quarter to the customer's margin balance.
On August 31, using Exhibit 2 market settlements, we derive the following for 25 December futures contracts:
5.62% = 100% - 94.38% yield on August 31,
1999 for one December 1999 futures contract on the CME
562 ticks = 10,000 basis points - 9,438 basis points
$985,950 = $1,000,000 notional - ($25)(562
ticks)
= $1,000,000 notional - ($2500)(5.62 listed yield of the STB futures contract)
=
$1,000,000 notional - ($250,000)(5.62%)
= $1,000,000 notional - ($14,050 discount)
This $985,950 "settlement price" is an artificial buying price against which the June 17 artificial sales "settlement price" is netted against in the day the sell-then-buy (STB) futures contracts are settled. The net difference is added or subtracted each quarter to the customer's margin balance. The difference is the value of one August 31 STB futures contract:
-$425 = $985,525 selling amount - $985,950 on Aug. 31 for one December 1999 STB futures contractThe aggregate for all 75 contracts is derived below using Exhibit 1 and Exhibit 2 data:
-$10,625 = -(5.79 June 17 settlement - 5.62 Aug. 31 settlement)($2,500)(25 contracts) for Dec. 1999 futuresThe above three sets of futures contracts negative values sum to the following:
-$45,000 = the aggregate liability caused by decreases in LIBOR between June 17 and August 31
But since this liability is not allowed to be carried in the
Futures Margin Account, MarginOOPS Bank must deposit sufficient cash from other sources to
bring the balance up to $500 on August 31, 1999. Note that there have not been any
cash settlements of any of these futures contracts as of August 31. The reason is
that LIBOR plunged and MarginOOPS "is losing" all futures
contracts as of August 31. This is why there is an "OOPS" in the
bank's name.
Assume that SFAS 133 and IAS 39 rules for adjusting derivative financial instruments to fair values apply in this instance. Use the hypothetical settlement prices given in Exhibit 2.
-$12,500
= -(5.79 June 17 settlement - 5.59 Dec. 17
settlement)($2,500)(25 contracts) for Dec. 1999 futures
-$15,000 = -(5.87 June 17 settlement - 5.63 Dec. 17 settlement)($2,500)(25 contracts) for Mar. 2000 futures
-$23,750 = -(6.08 June 17 settlement - 5.70 Dec. 17 settlement)($2,500)(25 contracts) for June 2000 futures
-$51,250 on September 17, 1999 date of settlement of the 15 September
futures contracts
-$51,250 = the aggregate loss caused by decreases in LIBOR between June 17 and September 17. We must also consider the $500 margin limit such that at least $51,750 must have been deposited to the margin account to bring its balance up to $500 on September 17, 1999.
The values of the remaining 50 contracts are computed below.
-$15,000 = -(5.87 June 17 settlement - 5.63 Sept.
17 settlement)($2,500)(25 contracts) for Dec. 1999 futures
-$23,750 = -(6.08 June 17 settlement - 5.70 Sept. 17 settlement)($2,500)(25 contracts) for June 2000 futures
-$38,750
Question
9Assume that SFAS 133 and IAS 39 rules for adjusting derivative financial instruments to fair values apply in this instance. Use the hypothetical settlement prices given in Exhibit 2.
Hint: Only the 25 contracts for March 2000 and 25 contracts for June 2000 remain on September 30, 1999.
-$11,875 = -(5.87 June 17
settlement - 5.68 Sept. 30 settlement)($2,500)(25 contracts) for Dec. 1999 futures
-$22,500 = -(6.08 June 17 settlement - 5.72 Sept. 30
settlement)($2,500)(25 contracts) for June 2000 futures
-$34,375 on September 30, 1999
-$34,375 = the aggregate loss caused by decreases in LIBOR between June 17 and September 30. However, since the MarginOOPS Bank had to deposit $51,750 in cash into this account as of the August 31, the net balance in the account is $17,375 on September 30, 1999.
Hint: Remember that cash withdrawals are not made at the end of any month. They are only made on settlement dates according to the Bank's policy.
Since the margin account of $17,375 exceeds the minimum
balance of $500, no more cash must be deposited. Following the bank's policy of only
withdrawing cash on the settlement dates, this balance is left in the account on September
30, 1999.
After computing the aggregate interest expense with the aggregate hedging amount from all 75 interest rate futures contracts, discuss the impact of the hedge upon the refunding costs for the funds raised to carry the $25 million loan receivable. In particular, comment as to whether the hedgings were "effective" in the context of SFAS 133.
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Insert Exhibit 3 About Here
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Hint: Hedge effectiveness is defined in Bob Jensen's online glossary at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm.
Hint:
The settlement for the first 25 contracts is shown as a guide for students.-$12,500
= -(5.79 June 17 settlement - 5.59 Sept. 17
settlement)($2,500)(25 contracts) for Sept. contracts
+$ 7.500 = -(5.87 June 17 settlement - 5.99 Dec.
17 settlement)($2,500)(25 contracts) for Dec. contracts
-$11,250 = -(6.08 June
17 settlement -
The total settlements aggregate to -$16,250 loss on the futures contracts.
Unfavorable cash settlements such as the -$12,500 cannot necessarily be withdrawn in cash since they may require cash deposits to the margin account rather than cash withdrawals if there is not a sufficient cushion in the margin account to cover the negative settlements. What is the netting of all cash deposits and withdrawals as a result of all futures contract settlements in the MarginOOPS Bank Case?
This answer is summarized in the Summary of Results section of Exhibit 4 of the MarginOOPS Bank Case.
Given the note payable rates in Exhibit 3, compute the interest expense of the initial quarter and all refundings in subsequent quarters. Then compare these aggregate "actual" interest payments with the fixed "expected" interest payments that you derived in Question 3 using the (91/360 yr) and (364/365) adjustment factors.
Hint: The interest expense paid out on September 17 is shown as a guide for students
(Note the tumbling interest expense in the second quarter! This required the cash feeding of the margin account.)
$379,167 = (6.00% on Sept.17,
1999)($25,000,000)(91/360 yr)
$376,007 = (5.95% on Dec. 17, 1999)($25,000,000)(91/360 yr)
$401,285 = (6.35% on June 17, 2000)($25,000,000)(91/360 yr)
$395,597 = (6.26% on June 17, 2000)($25,000,000)(91/360
yr)
$1,552,056 = actual interest expense from the quarterly
refundings
+$ 11,250 = loss from futures contracts (See
the Summary
of Results in Exhibit 4)
$1,563,306 = actual interest expense after
hedging outcomes
-$1,479,415 =
(5.86731%)($25,000,000) expected cost derived in Question 3
$ 83,891 = hedged
expectation error equal to actual interest expense minus expected
interest expense
6.25322% = actual hedged
interest rate based upon ($1,563,306 /
$25,000,000)
-5.86731% = expected hedged interest rate derived in Question 3
0.38591% = hedged expectation error rate
What are the main criteria for a cash flow hedge to be considered effective under SFAS 133? Was the hedging in MarginOOPS Bank effective or ineffective?
The main criteria are spelled out in Section 2 beginning in Paragraph 62 on Page 45 of SFAS 133. The margin of convergence error is relatively large in this case, but on a quarterly basis it is not so large as to be considered ineffective under SFAS 133 rules.
The hedge was only somewhat effective in achieving the expected fixed refunding cost of 5.86731% for the year. When interest rates dropped, the September 17, 1999 settlement loss of $-12,500 raised the net borrowing cost. When interest rates turned upward again, the December 17, 1999 settlement gain of $7,500 lowered the net borrowing cost. When interest rates dropped back down again, the June 17, 2000 settlement loss of -$11,250 raised the net borrowing cost. The hedged refunding costs totaled $1,568,306. This exceeded the expected hedged total of $1,479,415. Reasons for such discrepancies are explained in the MarginWHEW Bank Case.
Due to the net loss of $11,250 on the 75 futures contracts,
MarginOOPS Bank may be sorry for the hedges in retrospect since refunding interest
expenses dropped. However, by hedging the bank relieved itself of the worry of
rising interest rates by purchasing the effective hedge comprised of 75 interest rate
futures contracts on June 17, 1999. Interest rates just did not rise to make this a
profitable hedge. However, the goal of these hedging contracts is not to be
profitable. The goal is to fix the refunding costs of carrying the $25,000,000
fixed rate note receivable.
Question 11
What if the margin limit was doubled from $500 to $1,000? Would this make much of a
difference in the outcome?
The margin limit amount does not matter a great deal as long as it is set at any amount above zero. The fact that margin accounts cannot be negative is what really hurts hedging with interest rate futures contracts. The MarginOOPS Bank Case illustrates how the margin limits required that the bank make relatively large cash deposits into the Futures Margin Account in the period from June 17 to September 17 when LIBOR fell rather dramatically using the Exhibit 1 data. It did not matter much that the limit was $500 instead of $100 or $1,000. What mattered is that plunging interest rates required that the bank make rather substantial deposits into the account to keep it from being a liability account.
Note that a Futures Margin Account can never be a
liability since it never has a credit balance.
Question 12
Are the changes in the value of the Eurodollar futures contracts in this case
debited/credited to current earnings or Other Comprehensive Income (OCI) under IAS 39?
Although it is probably not true for MarginOOPS Bank, for purposes of this question assume
that the cost of capital in MarginOOPS Bank is perfectly correlated with movements of
LIBOR just as CME Eurodollar futures contracts settlements are perfectly correlated with
LIBOR movements.
Hint: See the terms "Cash Flow Hedge" and "Comprehensive
Income" at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#C-Terms
.
Also see Paragraphs 30 and 31 on Pages 21-22 of SFAS 133.
IAS 39 does not have OCI requirements comparable to the OCI requirements in SFAS 130 and SFAS 133. In England, the OCI reconciliation statement is called a "Struggle Statement." However, the IASC does not yet require OCI and Struggle Statements. You can read more about OCI under the definition of Other Comprehensive Income and Struggle Statements in http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm .
Question 13
Are the changes in the value of the Eurodollar futures contracts in this case
debited/credited to current earnings or Other Comprehensive Income (OCI) under SFAS
133? Although it is probably not true for MarginOOPS Bank, for purposes of this
question assume that the cost of capital in MarginOOPS Bank is perfectly correlated with
movements of LIBOR just as CME Eurodollar futures contracts settlements are perfectly
correlated with LIBOR movements.
Please discuss the implications of portfolio hedging versus having the futures contracts tied to a specific hedged item such as a notes payable for $25 million that must be refunded at a variable interest rate.
Hint: See the terms "Cash Flow Hedge" and
"Comprehensive Income" at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#C-Terms
.
Also see Paragraphs 30 and 31 on Pages 21-22 of SFAS 133.
Paragraph 241 on Page 130, Paragraph 317 on Page 155, Paragraphs 333-334 beginning on Page 159, Paragraph 432 on Page 192,
- Paragraph 21 on Page 13,
- Paragraph 29 beginning on Page 20,
The journal entries are shown in Exhibit 4 assuming that all value changes in the futures contracts are charged to current earnings and not the OCI account.
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Question 15
The main advantage is that such contracts have no cost (premiums) at the date of acquisition. If they steadily increase in value as illustrated in the MarginWHEW Bank Case, then there is never a cash outlay and the cash rolls in for STB futures contracts as interest rates rise. It rolls in for BTS futures contracts as interest rates fall.
The huge disadvantage of such contracts is that they can be very risky and the level of risk is not fixed. In the MarginOOPS Bank Case, the bank had to keep throwing money into the Futures Margin Account when interest rates plunged. If they had continued to plunge, the loss could have become immense.
The main advantage of options contracts in the place of futures contracts is that the risk is known and fixed at an amount equal to the initial level of investment in the purchase cost of the futures contracts. For example, when CapIT Bank purchased 25 put contracts for $53,125 on Dec. 17, the maximum harm done, no matter what, is $53,125 from purchasing the futures. In other hedging alternatives such as interest rate forward/futures contracts, the initial investment may be almost zero, but the loss risk may soar with big changes in LIBOR. Futures and forward contracts expose the holder to enormous risks. Futures holders have no risks beyond the cost of the futures. Acquistions of hedging futures are quick and easy if satisfactory deals are traded on open exchange systems such as the Chicago Board of Futures Exchange.
Interest rate swaps have the advantage of both having a low
initial cost and fixed risk if a variable price of interest is swapped for a fixed price.
The problem with interest rate swaps is that they are custom contracts in which counter
parties to the swap must be located and dealt with in private or brokered negotiations.
Also it is better if the swap periods coincide.
Question 16
It was stressed that the 75 futures contracts were "cash flow hedges." How would
the journal entries change if they were "fair value hedges" as defined in
SFAS 133? Is the distinction between cash flow versus fair value hedges as relevant in the
international IAS
39 standard as it is in the U.S. SFAS
133 standard? Where is there a major illustration of using futures contracts to
hedge fair value in SFAS 133?
Hint: The terms "cash flow hedge" and "fair value hedge" have important distinctions in SFAS 133. You may find references to parts of that standard by looking up these terms in http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#0000Begin .
Changes in futures contract values may not be placed in OCI under SFAS 133 rules unless the hedges are designated as cash flow hedges. The distinction is between cash flow hedges and fair value hedges is less important in IAS 39 rules since there is no OCI alternative for either type of hedge in IAS 39.
The major example of using futures contracts to hedge fair value
is Example 1 beginning in Paragraph 105 on Page 59 of SFAS 133.
The Futures Margin Account is a cash equivalent much like other cash equivalents such as certificates of deposit. Cash may be withdrawn at any time as long as the balance left in the Futures Margin Account does not fall below the margin limit. Firms often leave a cushion in the account to cover downturns in value. They probably would not leave as much cushion as was left by MarginOOPS Bank on various dates.
For a copper price swap analysis, see the Mexcobre Case.
For hedging via futures contracts, see the MarginWHEW Bank Case.
For hedging via futures contracts, see the CapIT Bank Case.
For hedging via futures contracts, see the FloorIT Bank Case.