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 Jensen’s 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:

 

Bob Jensen's Home Page

Case Objectives Case Introduction Case Questions
Glossary Mexcobre Case CapIT Corp. & FloorIT Banks MarginWHEW & MarginOOPS Banks

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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Insert Exhibit 1 About Here

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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.)

Question 1
Exhibit 1
shows selected Eurodollar interest-rate futures settlements taken from the June 17, 1999 Wall Street Journal. So that students are consistent in the main settlements, the calculation outcomes are provided for two rows in the table below.  Students are to compute the results for the two bottom rows.

Date

Settlement Price Expressed as an APR %

Yield Shown In Exhibit 1

Settlement Total for
25 contracts

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 that 25 futures contracts (that each have a $1 million notional) are purchased on June 17 in order to lock in a loan profit for MarginOOPS Bank across the four quarters.

  • 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.


Question 2
What are quarterly yields corresponding to the above annual yields?

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
Based on (90/360 yr)

Quarterly Yield
Based on (91/360 yr)

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
Based on (90/360 yr)

Quarterly Yield
Based on (91/360 yr)

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)


Question 3 

What is the hedged annual APR cost of the underlying loan's refundings rate locked-in by the acquisition of the 75 STB futures contracts used to hedge the profit on the $25 million loan?   Compute this rate on both the (90/360 yr) quarterly factors and the (91/360 yr) factors.

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.


What is the locked-in annual rate using the (90/360 yr) factors derived in Question 3 above?

5.788693% APR = [(1 + 0.01360000)(1 + 0.01475000)(1 + 0.01467500)(1+0.01520000) - 1 ][360/365)]


What is the locked-in annual rate using the (91/360 yr) factors derived in Question 3 above?

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) factors
$1,479,415 = (5.91766%)($25,000,000) hedge cost using (91/360 yr) factors


Question
What is the hedged annual APR loan profit rate and aggregate dollars locked-in by the acquisition of the 75 STB futures contracts used to hedge the profit on the $25 million loan?  For this computation, ignore reinvestment opportunities on the $500,000 received each quarter on the note receivable of $25,000,000.

From 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 5 
What is the annual gross profit that MarginOOPS Bank anticipates after hedging the cost of refunding the 8.00% loan for 12 months?  Express your answer in dollars.

$520,585 = ($25,000,000)(2.08234%) if reinvestment of interest received on the loan is ignored

Question
Why is the computation of the hedged profit on the loan less reliable than the computation of the hedged cost of refundings for that loan (assuming interest rate futures contract hedging)?

The problem with the revenue stream is that it is fixed at 8.00% spread quarterly in amounts of $500,000 every three months.  Ideally, the reinvestment rate would be the cost of capital of MarginOOPS Bank. However, we are not given that rate, and estimating such a future cost of capital is very difficult.  If we ignore the opportunity to reinvest the $500,000 every quarter, the profits are understated. 

A 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
This question calls for calculating 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.  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.  Please adhere to the following policies regarding cash flows in the Futures Margin Account:

  • 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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Insert Exhibit 2 About Here

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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 contract
  -$10,625 = ($425)(25 contracts) = the balance sheet liability component on Aug. 31, 1999 
                                                        for 25 December 1999 futures contracts

This same answer can be computed quickly as follows using yield rates:
-$10,625 = -(5.79
June 17 settlement - 5.62 August 31 settlement)($2,500)(25 contracts)

The 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 futures
-$13,125  = -(5.87 June 17 settlement - 5.66 Aug. 31 settlement)($2,500)(25 contracts) for Mar. 2000 futures
-$21,250  = -(6.08 June 17 settlement - 5.74 Aug. 31 settlement)($2,500)(25 contracts) for June 2000 future
s

The 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.

Question 8
First compute the cash settlement of the 25 December 1999 futures contracts on December 17, 1999.   Then compute the cash withdrawal of cash settlements from the Futures Margin Account according to MarginOOPS Bank policy.  What is the balance sheet asset or liability reported in the financial statements for the Futures Margin Account on December 17, 2000 for all the remaining futures contracts acquired by MarginOOPS Bank on June 17?

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


What are the September 17 hypothetical settlement values for all the 75 contracts using Exhibit 1  and Exhibit 2 data?

Hint:  The settlement for the first 25 contracts is shown as a guide for students.

-$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


What is the aggregate contribution of the above 75 hedge settlements toward fixing the profit on the 8.00%, one-year note receivable?

-$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.


Following MarginOOPS Bank policy, the September 2000 futures are settled for cash and the settlement is withdrawn from the Futures Margin Account.  How much cash is withdrawn from the account?  What is the revised balance in that account?

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


What is the aggregate contribution of the above 50 hedge settlements toward fixing the profit on the 8.00%, one-year note receivable?

-$38,750  = the aggregate asset loss caused by decreases in LIBOR between June 17 and September 17.  To this we must add cash to make up this loss plus initial $500 margin deposit such that the balance in the Futures Margin Account is $500 on September 17, 1999.  Hence none of the settlement on September 17 can be withdrawn.  The settlement is negative.

 

Question 9
What is the balance sheet asset or liability reported in the financial statements for the Futures Margin Account on September 30, 1999 for all the remaining futures contracts acquired by MarginOOPS Bank on June 17. 

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

Hint:  Only the 25 contracts for March 2000 and 25 contracts for June 2000 remain on September 30, 1999.


What are the settlements on September 30 for the remaining 50 futures contracts?

-$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 future
s
-$34,375 on September 30, 1999


What is the aggregate contribution of the above 50 hedge settlements toward fixing the profit on the 8.00%, one-year note receivable?

-$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.


Following MarginOOPS Bank policy, what is the revised balance in that account on September 30?

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.

Question 10
First compute the cash settlements of all futures contracts that were settled on September 17, 1999, December 17, 1999, and June 17, 1999.  Use the hypothetical settlement prices given in Exhibit 2.  Discuss the impact of all the interest rate futures in the MarginOOPS Bank case.  Next compute the interest expense for the first three months from June 17 to September 17 in 1999, and then add to this the refunding costs for each quarter thereafter up to June 17, 2000.  Use the hypothetical interest rates shown in Exhibit 3.

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.


What are the cash settlements on September 17, December 17, and June 17  for the 75 interest rate futures contracts acquired on June 17, 1999?  What is their aggregate contribution toward fixation of the profit on the 8.00% note receivable?

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 - 5.90 June 17 settlement)($2,500)(25 contracts) for June contracts

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.

With respect to Paragraph 29a on Page 20 of SFAS 133, it should be noted that if the hedged item is a portfolio of assets or liabilities based on an index (such as the U.S. Prime), the hedging instruments cannot use another index (such as LIBOR) even though the two indices are highly correlated.   However, if both are based entirely upon the same index, there is a perfect correlation between the hedged item (e.g., the cost of capital in MarginOOPS Bank) and the Eurodollar interest rate futures hedging instruments.  In that case, it would seem that the value changes in the hedging instruments could be carried in OCI until the futures contracts are settled.

The hedging instrument (e.g., a forecasted transaction or firm commitment foreign currency hedge) must meet the stringent criteria for being defined as a derivative financial instrument under SFAS 133.  This includes the tests for being clearly-and-closely related.  It also includes strict tests of Paragraphs 21 beginning on Page 13 , 29 beginning on Page 20, and Paragraph 56 on Page 33 of SFAS 133 with respect to the host contracts that are being hedged.  Those tests state that if the forecasted "transaction" is in reality a group or portfolio of individual transactions, all transactions in the group must bear the same risk exposure within a 10% range discussed in Paragraph 21.  Also see Footnote 9 on Page 13 of SFAS 133.  The grouping tests are elaborated upon in the following Paragraphs:

  • Paragraph 21 on Page 13,
  • Paragraph 29 beginning on Page 20,
  • Paragraph 241 on Page 130,
  • Paragraph 317 on Page 155,
  • Paragraphs 333-334 beginning on Page 159,
  • Paragraph 432 on Page 192,
  • Paragraph 435 on Page 193,
  • Paragraph 443-450 beginning on Page 196
  • Paragraph 462 on Page 202,
  • Paragraph 477 on Page 208.

Question 14
What are the journal entries for all transactions in this case with a $500 margin limit below which the account called "Futures Margin Account" cannot fall.  If marking-to-market makes this fall below $500, add more cash to the account to bring it up to $500.  Assume SFAS 133 rules are in effect.  Also assume that the hedged item is the particular note payable that is refunded each quarter using interest rates shown in Exhibit 3.

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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Insert Exhibit 4 About Here

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Question 1
Hedging a borrowing cost via an interest rate futures contract is only one of several alternatives for hedging. Other alternatives include interest rate swaps and interest rate options. What are the key advantages and disadvantages of futures contracts in hedging interest rates?

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.

Question 17
What is the basic difference between the Cash Account and the Futures Margin Account?

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.