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
Update Warning: Since futures contracts are settled daily, a 0.0% discount rate should be used as illustrated in Example 7 of Appendix B in FAS 133. The illustration in Exhibit 4 of this case illustrates the discounting versus the non-discounting solutions. Professor Walter Teets sent me the following email message concerning his changing of the original answers in the Teets and Uhl case entitled "C.L. Smith and Sons: Accounting for Futures Hedging Commodity Purchases and Sales" at http://www.gonzaga.edu/faculty/teets/index0.html
| September 7, 2000 The error in our (Teets and Uhl) case is simply that the futures values (due to changes in either spot or futures prices) shouldn't be present valued, since there is daily settling up. But the (change in) values of the anticipated cash flows of the hedged item should be present valued, because there is usually no periodic settling of the cash flows associated with the hedged item. The change to the case is minor; the major point of the futures case is to show exclusion of the change in the difference between future and spot price from the determination of effectiveness. Present valuing the cash flow associated with the anticipated transaction, while not present valuing the futures (change in) value adds additional ineffectiveness to the hedging relation. Walter Teets at Gonzaga University |
Effectiveness Test Warning:
| Most hedging contracts other than options base hedge
effectiveness tests on full value rather than intrinsic value of
changes in the hedging instrument's value. Because full value
tests of effectiveness in the case below would sometimes deny hedge
accounting, the case below illustrates hedge effectiveness strategy
based upon intrinsic values. There can be no ineffectivness in
terms of intrinsic value each period in the case below.
Read More About This |
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 variable
rate 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 a firm commitment 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 forecasted transaction refunding costs 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-short) contracts gain from soaring futures prices caused by plunging interest rates, whereas holders of buy-then-sell (BTS-long) 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-short 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-short 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 September 1999 futures contract having a listed settlement of 94.56 will have a discount of $13,600 = (100% - 94.56%)($1,000,000)(3/12 yr). The discounted price becomes $986,400 = $1,000,000 - $13,600. 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
5.44% = 100% - 94.56% yield on June 17, 1999 for a
September 1999 futures contract
544 ticks = 10,000 basis points - 9,456 basis points
$986,400 = $1,000,000 notional - ($25)(544 ticks)
= $1,000,000 notional - ($2500)(5.44 listed yield of the
futures contract)
= $1,000,000 notional - ($250,000)(5.44%)
= $1,000,000 notional - ($13,600 discount)
This $986,400 "settlement price" is an artificial settlement price. The net difference is added or subtracted each quarter to the customer's margin balance. Rises in settlements caused by declines in discount yields benefit STB-short positions and hurt BTS Long positions. Similarly rises in yields benefit BTS-long positions.
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:
$13,600 = $1,000,000 - $986,400 discount on June 17, 1999 for a September 1999 futures contract
1.3600% = ($13,600 discount) / ($1,000,000 notional) yield for (3/12 yr)
5.4400% APR = (1.3600%)(4 quarters of the year) APR 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 buy-then-sell (BTS-long) 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 acquire 25 buy-then-sell (BTS-long) futures contracts on each of three remaining 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 interest rates soar and make notes payable refunding more expensive, the BTS-long futures hedging contracts have plunging purchase prices (and soaring yields) 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. Reasons that futures hedging is only approximate are discussed in the MarginWHEW Bank Case.
On June 17, MarginOOPS Bank loaned $25 million at a fixed rate of 8.00%
receivable at
2.00% quarterly. MarginOOPS funded its loan for the first three months at
a quarterly rate of 1.4939% (See Exhibit 3). The Bank 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
BTS-long futures contracts for September 1999 (25 contracts), December 1999 (25 contracts), and
March 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 |
|
Acquisition Date |
Sept1999 Settlement |
94.56% APR |
5.44% APR |
$24,638,125 |
Dec. 1999 Settlement |
94.21% APR |
5.87% APR |
$24,633,125 |
Mar. 2000 Settlement |
94.13% 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 at the end of each month and on dates futures contracts expire. To further simplify the case, it will be assumed that no cash withdrawals are taken from the margin account when its balance exceeds $500 between June 17, 1999 and March 17, 2000. On March 17, 2000 after the last futures contracts are settled, assume the margin account is closed out to cash. However, more cash must be added to bring the margin account up to its minimum $500 balance on any accounting date in 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 buy-then-sell (BTS-long) 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.
Part A:
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.
$24,660,000 = [$1,000,000 -
($2,500)(5.44)][25 contracts] for 25 September 1999 contracts
$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
Part B:
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. The Bank must make a $500 margin account deposit, but this is not related to the futures prices on June 17.
Part C:
How much does MarginOOPS Bank have to deposit into the
Futures Margin Account on June 17?
$500 as stated above.
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 17 1999 |
5.91% APR |
1.477% |
1.4939% |
September 17 1999 |
5.44% APR |
1.3600% |
1.375111% |
December 17 1999 |
5.79% APR |
1.4475% |
1.463583% |
March 17 1999 |
5.87% APR |
1.4675% |
1.483806% |
| Date | Annual Yield |
Quarterly
Yield |
Quarterly
Yield |
June 17, 1999 |
5.91% APR |
(5.91%)(3/12 yr) |
(5.91%)(91/360 yr) |
September 1999 |
5.44% APR |
(5.44%)(3/12 yr) |
(5.44%)(91/360 yr) |
December 17, 2000 |
5.79% APR |
(5.79%)(3/12 yr) |
(5.79%)(91/360 yr) |
March 17, 2000 |
5.87% APR |
(5.87%)(3/12 yr) |
(5.87%)(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.
5.73950% APR = [(1 + 0.0014775)(1 + 0.01360000)(1 + 0.01447500)(1+0.01467500) - 1 ][360/365)]
Note that the (9/12 yr) factor is equivalent to (90/360 yr) factor. To adjust for the full year, the final component in the equation becomes (360/365).
5.74084% APR = [(1 + 0.014939)(1 + 0.013751111)(1 + 0.01463583)(1+0.01483806)- 1][360/364]
Part
C:$1,434,874 = (5.73950%)($25,000,000) hedge cost using (90/360 yr) factors
Question 4
What is the hedged annual APR loan profit rate and aggregate dollars locked-in by
the acquisition of the 75 BTS-long 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:
2.26% APR =
(8.00%
note receivable) - (5.74084%
hedged cost of
refunding)
=
hedged profit spread 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.
$565,000 = ($25,000,000)(2.26%) if reinvestment of interim-period interest received on the loan is ignored
Question 6
Why is the computation of the hedged profit on the loan less reliable than the computation
of the hedged cost of refunding 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 7
This question calls for calculating the balance sheet asset or liability reported in the
financial statements for the Futures Margin Account on June 30, 1999
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. Also assume there has been no cash settlement since the $500 was put
into the futures margin account. Use the hypothetical settlement prices given in Exhibit 2.
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Part A:
What is the cash settlement on June 30 and the balance in the futures margin
account 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.
Margin account settlements can be derived from yields shown in Exhibit 2.
|
Assumption Although margin accounts are normally settled daily, the settlements in this case will only be at the end of each month and on dates futures contracts expire. To further simplify the case, it will be assumed that no cash withdrawals are taken from the margin account when its balance exceeds $500 between June 17, 1999 and March 17, 2000. On March 17, 2000 after the last futures contracts are settled, assume the margin account is closed out to cash. However, more cash must be added to bring the margin account up to its minimum $500 balance on any accounting date in the illustration. |
Recall that we earlier computed the following using the June 17 Wall Street Journal settlements shown in Exhibit 1:
$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
5.44% = 100% - 94.56% yield on June 17, 1999 for a
Sept. 1999 futures contract
544 ticks = 10,000 basis points - 9,456 basis points
$986,400 = $1,000,000 notional - ($25)(544 ticks)
= $1,000,000 notional - ($2500)(5.44 listed yield of the futures contract)
= $1,000,000 notional - ($250,000)(5.44%)
= $1,000,000 notional - ($13,600 discount)
This $986,400 "settlement price" is an artificial selling price against which the eventual artificial purchase "settlement price" is subtracted at the day the buy-then-sell (BTS-long) futures contracts are settled. The net difference is added or subtracted each quarter to the customer's margin balance.
On June 30, using Exhibit 2 data, we derive the following for the September futures contracts:
5.40% = 100% - 94.60% yield on
June 30,
1999 for a September 1999 futures contract
540 ticks = 10,000 basis points - 9,460 basis points
$986,500 = $1,000,000 notional -
($25)(540
ticks)
= $1,000,000 notional - ($2500)(5.40 listed yield of the BTS-long futures contract)
=
$1,000,000 notional - ($250,000)(5.40%)
= $1,000,000 notional - ($13,500 discount)
This $986,500 "settlement price" is an artificial buying price against which the June 17 artificial sales "settlement price" is netted against in the day the buy-then-sell (BTS-long) 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 June 30 BTS-long futures contract:
-$100 = $986,400 June 17 "sell" -
$986,500 Aug. 31 "buy" for one September 17
futures contract
-$2,500 = (-$100)(25 contracts) = decline in value for
the 25 September 17 futures contracts
This same answer can be computed
quickly as follows using yield rates:
-$2,500 = (5.40 June 30 settlement - 5.44 June 17 settlement)($2,500)(25 contracts)
The aggregate for all 75 contracts is derived below using Exhibit 1 data:
-$
2,500 = (5.40 June 30 - 5.44 June 17)($2,500)(25 contracts) for Sept. 1999 futures
-$ 2,500 = (5.75 June 30 - 5.79 June 17)($2,500)(25 contracts) for Dec. 1999 futures
-$ 2,500 = (5.83 June 30 - 5.87 June 17)($2,500)(25 contracts) for March 2000 futures
-$ 7,500
= June 30 net loss in value on the 75 BTS-long futures contracts acquired on June
17
The $7,500 is the aggregate cash flow loss caused by decreases in the futures contract values
Part
B:Since a 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 at all times. Note that there have not been any cash settlements of any of the 75 futures contracts as of June 30. This case assumes monthly settlements in the margin account. Hence, to maintain a minimum of $500 in the Futures Margin Account, the MarginOOPS Bank must deposit an additional $7,500 in cash to cover the losses arising from declines in LIBOR. This is why there is an "OOPS" in the Bank's name. The Bank had to put $500 into the margin account on June 17 and an additional $7,500 on June 30.
Question 8
First compute the cash settlement of the September 1999 futures on September 17, 1999.
Then compute net cash additions and withdrawals from the Futures Margin
Account at the end of the day on September 17 according to MarginOOPS Bank policy. What is the balance sheet asset or
liability reported in the financial statements for the Futures Margin Account on September
17, 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.
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Assumption Although margin accounts are normally settled daily, the settlements in this case will only be at the end of each month and on dates futures contracts expire. To further simplify the case, it will be assumed that no cash withdrawals are taken from the margin account when its balance exceeds $500 between June 17, 1999 and March 17, 2000. On March 17, 2000 after the last futures contracts are settled, assume the margin account is closed out to cash. However, more cash must be added to bring the margin account up to its minimum $500 balance on any accounting date in the illustration. |
Part A:
What is the net cash withdrawn from or
deposited into the Futures Margin Account for the 75 contracts using Exhibit 1 and Exhibit 2 data?
Margin account settlements can be derived from yields shown in Exhibit 2.
Hint: The settlement for the first 25 contracts is shown as a guide for students. The multiplication factor is $62,500 = ($2,500)(25 contracts).
-$14,375
= (5.21 Sept. 17 settlement - 5.44 June 17 settlement)($62,500) for Sept 1999 futures
-$12,500 = (5.59 Sept. 17 settlement - 5.79 June
17 settlement)($62,500) for Dec.1999 futures
-$15,000 = (5.63 Sept. 17 settlement - 5.87 June
17 settlement)($62,500) for Mar 2000 futures
-$41,875 = Net loss in cash on the 75
BTS-long futures contracts between June 17 and Sept 17
-
$42,375 = $41,875 net loss + $ 500 margin account depositThe total cash deposited is the $500 put in on June 17 plus the added $41,875 net deposits added sometime between June 17 and the close of the business day on September 17.
Part B:
What is the net balance in the Futures
Margin Account on September 17, 1999?
The Futures Margin Account is at its minimum balance of $500.
Question 9
Part A:
Including the initial margin deposit of $500 on June 17, how much cash has been
deposited into the Futures Margin Account between June 17 and September 17,
1999?
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.
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Assumption Although margin accounts are normally settled daily, the settlements in this case will only be at the end of each month and on dates futures contracts expire. To further simplify the case, it will be assumed that no cash withdrawals are taken from the margin account when its balance exceeds $500 between June 17, 1999 and March 17, 2000. On March 17, 2000 after the last futures contracts are settled, assume the margin account is closed out to cash. However, more cash must be added to bring the margin account up to its minimum $500 balance on any accounting date in the illustration. |
- (-$27,500 = (5.59-5.79)($62,500) +
(5.63-5.87)($62,500) value on September 17, 1999)
- (-$14,375 = (5.21-5.44)($62,500) value of the 25 contracts settled on
September 17, 1999)
+ $41,875 = decline in value of the Margin Futures Account
between June 17 and Sept. 17
+ $ 500 = Margin Deposit Account balance
carried forward from September 17
+ $42,375
= cash deposited in the Margin Futures up to Account on Sept. 17,
1999
Part B:
How did the values of the remaining 50 futures contracts do between September 17
and September 30?
+(-$23,125 = (5.61-5.79)($62,500) +
(5.68-5.87)($62,500) value on September 30, 1999)
-(-$27,500 = (5.59-5.79)($62,500) + (5.63-5.87)($62,500) value on September 17,
1999)
+ ( $4,375 =
(5.61-5.59)($62,500) + (5.68-5.63)($62,500) change in value)
Interest rates increased between September 17 and September 30 and futures prices declined such that the aggregate net loss is improved by $4,375 for the 50 remaining BTS-long contracts after September 17. Nothing can be done to recover the loss on the 25 contracts that expired on September 17.
Part C:
Following MarginOOPS Bank policy
of leaving all cash above $500 in the Futures Margin Account, what is the
balance of this account on September 30? If the Margin Account Balance
were zeroed out, what would be the net cash lost between June 17 and September
30, 1999?
Hints: First compute the September 30 value of the 50 remaining contracts on September 30. Use the yields shown in Exhibit 2 for June 17, 1999 and September 30, 1999. Then compute the value of the 50 contracts on September 17 plus the value lost on the contracts that were settled on September 17. The value of the 50 contracts on September 30 less the value of the 75 contracts on September 17 is the change in the balance of the Futures Margin Account between September 30 and September 17. Then add the $500 starting balance in the Futures Margin Account. Note that the multiplication factor is $$62,500 = ($2,500 per contract)($25 contracts).
+(-$23,125 = (5.61-5.79)($62,500) +
(5.68-5.87)($62,500) value on September 30, 1999)
- (-$27,500 = (5.59-5.79)($62,500) + (5.63-5.87)($62,500) value on September 17,
1999)
+ $ 4,375 = increase in value of the Margin Futures Account on
September 30, 1999)
+ $ 500 = Margin Deposit Account balance
carried forward from September 17
+ $4,875 = ending
balance in in the Margin Futures Account on September 17, 1999
It would be possible to withdraw all but $500 of the above balance, but to simplify the case the policy is to leave all cash above $500 in the account until all contracts are settled.
Yet another way of looking at this is to compute the deduct the all cash deposited in the Margin Futures Account between June 17 and September 30 and deduct the above ending balance to derive the net loss in cash on the futures account between June 17 and September 30.
+ $
4,875 = ending balance in in the Margin Futures Account on September 17, 1999It can be misleading to call this net cash "lost," because the futures contract are hedging a variable rate loan. The net cash "lost" in the futures contracts is "recovered" in the repricing of the $25,000,000 note payable.
Question 10
Part A:
First compute the cash settlements of all 75 futures contracts that were settled
when the futures contracts expired on September
17, 1999, December 17, 1999, and March 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.
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Exhibit 3 is Combined With Exhibit 2
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What are the ex post cash settlements on September 17, December 17, and March 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.
- $14,375
= (5.21 Sept. 17 settlement -5.44 June 17
settlement)($2,500)(25 contracts)
+$10,000 =
(5.95 Dec. 17 settlement - 5.79 June 17 settlement)($2,500)(25 contracts)
-
$13,750 =
(5.65 Mar. 17 settlement - 5.87
June 17 settlement)($2,500)(25 contracts)
-$18,125
The settlements on all 75 futures contracts aggregate to -$13,125 ex post.
Part B:
Use the Exhibit 3
quarterly interest rates to compute the interest expense actually paid ex post
on the $25 million.
|
Notes Payable Loan Period |
Quarterly Rate |
Interest Expense |
| June 18, 1999 to September 17, 1999 | 1.3599% | $373,479 = (.013599)($25,000,000) |
| September 18, 1999 to December 17,1999 | 1.3170% | $359,243 = (.01317)($25,000,000) |
|
December 18, 1999 to March 17, 2000 |
1.5040% | $376,007 = (.01504)($25,000,000) |
| March 18, 2000 to June 17, 2000 | 1.3625% | $340,618 = (.013625)($25,000,000) |
| June 18, 1999 to June 17, 2000 |
|
Total = $1,355,854 |
Then compare the actual interest payments with what might have been paid if the MarginOOPS Bank had instead paid a constant 1.4939% every quarter on the $25 million.
|
Notes Payable Loan Period |
Unhedged Interest Expense Actually Paid |
Hypothetical Interest Expense at 1.4939% |
| June 18, 1999 to September 17, 1999 | $339,986 = (.013599)($25,000,000) | $373,479 = (.014939)($25,000,000) |
| September 18, 1999 to December 17,1999 | $329,243 = (.013170)($25,000,000) | $373,479 = (.014939)($25,000,000) |
|
December 18, 1999 to March 17, 2000 |
$376,007 = (.015040)($25,000,000) | $373,479 = (.014939)($25,000,000) |
| March 18, 2000 to June 17, 2000 | $340,618 = (.013625)($25,000,000) | $373,479 = (.014939)($25,000,000) |
| June 18, 1999 to June 17, 2000 |
Total = $1,385,854 |
Total = $1,493,916 |
Part C:
What is the netting of all cash deposits
and withdrawals as a result of all futures contract settlements in the MarginOOPS Bank
Case?
$1,507,055 = unhedged interest expense
actually paid
-$
13,125 = net cash
outflows as a result of the 75 hedging contracts
$ 1,520,180 = hedged interest expense actually paid after
hedging outcomes are added to the interest expense paid
This answer is summarized in the Summary of Results section of Exhibit 4 of the MarginOOPS Bank Case.
Part D:
In retrospect, was hedging a good decision? Why weren't the 75 futures
contracts a perfect hedge of interest rates on the $25 million loan
profit? Were they an effective hedge under SFAS 133 rules?
Hint: Hedge effectiveness is defined in Bob Jensen's online glossary at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm.
The 75 contracts were supposed to provide a locked-in rate computed in Question 3 as shown below:
5.907131% APR = [(1 + 0.014939)(1 + 0.013751111)(1 + 0.01463583)(1+0.01483806)- 1][364/365]
Hedging was not a good decision in retrospect since the outcomes were as follows
$1,507,055 = unhedged interest
expense actually paid
-$
13,125 = net cash
outflows as a result of the 75 hedging contracts
$ 1,520,180 = hedged interest expense actually paid after
hedging outcomes are added to the interest expense paid
However, hedging may have been a good decision ex ante. If interest rates had soared, the unhedged interest expense would have soared. Hedging would then have fixed the level of interest expense. In retrospect, interest rates went down rather than up (see Exhibit 2) such that hedging was more expensive than not hedging.
These interest rate futures hedges are rarely perfect due to reasons given in the MarginWHEW Case. The are, however, effective from the standpoint of SFAS 133 cash flow hedging criteria. 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.
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 in the balance sheet unless the company fails to live up to its
contractual agreements in futures contracting.
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,
Question 14
FAS 133 allows MarginOOPS Bank to avoid testing for cash flow hedge
effectiveness in this Eurodollar futures hedging illustration provided the hedge
is is declared as a hedge of the loan's refunding at spot rates. Why is
this allowed? When the Margin Futures Account (or the Futures Account)
balance is adjusted for futures settlement movements, what amount is,
thereby, supposed to go to OCI and what amount is supposed to go to current
earnings?
Hint: See a 1999 book entitled Introductory Cases on
Accounting for Derivative Instruments and Hedging Activities by Walter R.
Teets and Robert Uhl. In particular read about hedging with futures
contracts and see the C.I. Smith and Sons Case. The book, cases, and Excel
programs written by Teets and Uhl can be downloaded free from http://www.gonzaga.edu/faculty/teets/index0.html.
Trinity University students will find this book and accompanying files on the
path
J:\courses\acct5341\readings\teets\derivcas.pdf
Teets and Uhl (1999, p. 14) state the following:
If the company has chosen to measure variability in anticipated cash flows by changes in spot prices, the portion of the change in value of the futures due to changes in spot prices will exactly offset the change in expected cash flows due to a change in spot prices, discounted to present value. This portion of the change in value of the futures is therefore an effective hedge of the anticipated transaction, and is reflected in OCI. The change in the value of the futures contract due to the change in the difference between futures prices and spot prices will be excluded from determination of hedge effectiveness, and will be reflected in net income. The entire fair value of the futures contract will still be reflected as an asset or liability in the balance sheet. At the end of each accounting period, the following journal entry will be made to record the change in value of the futures contracts, and to apportion the change into OCI and net income. (The journal entries made at each balance sheet date will use the same accounts, but whether the entries to specific accounts are debits or credits will depend on the relative changes in futures and spot prices.)
Futures Contracts XX
OCI YY
Other Income ZZThe accounting for situations in which futures contracts are used as hedging instruments is illustrated in the fourth case, "C.L. Smith and Sons: Accounting for Futures Hedging Commodity Purchases and Sales."
The change in the futures contract value is affected by spot rate movements and futures price movements. If the Note Payable is refunded at spot rates, that portion of the hedge's value change that is attributable to spot rates should be perfectly effective in hedging the refunding cost at spot rates. The FASB reasons that such a perfect hedge should not have to be subject to quarterly effectiveness testing required of most hedges. That portion of a futures contract's value change that is attributable to the change in spot rates can be deferred in OCI as a perfectly effective hedge. The remaining portion of the value change impacted by futures price movements net of spot rate changes must be debited or credited to current earnings as opposed to OCI.
Update Warning: Since futures contracts are settled daily, a 0.0% discount rate should be used as illustrated in Example 7 of Appendix B in FAS 133. The illustration in Exhibit 4 of this case illustrates the discounting versus the non-discounting solutions. Professor Walter Teets sent me the following email message concerning his changing of the original answers in the Teet and Uhl case entitled "C.L. Smith and Sons: Accounting for Futures Hedging Commodity Purchases and Sales" at http://www.gonzaga.edu/faculty/teets/index0.html
| September 7, 2000 The error in our case is simply that the futures values (due to changes in either spot or futures prices) shouldn't be present valued, since there is daily settling up. But the (change in) values of the anticipated cash flows of the hedged item should be present valued, because there is usually no periodic settling of the cash flows associated with the hedged item. The change to the case is minor; the major point of the futures case is to show exclusion of the change in the difference between future and spot price from the determination of effectiveness. Present valuing the cash flow associated with the anticipated transaction, while not present valuing the futures (change in) value adds additional ineffectiveness to the hedging relation. Walter Teets at Gonzaga University |
Question 1
4Hint: See a 1999 book entitled Introductory Cases on Accounting for Derivative Instruments and Hedging Activities by Walter R. Teets and Robert Uhl. In particular read about hedging with futures contracts and see the C.I. Smith and Sons Case. The book, cases, and Excel programs written by Teets and Uhl can be downloaded free from http://www.gonzaga.edu/faculty/teets/index0.html.
Teets and Uhl (1999, p. 14) state the following:
If the company has chosen to measure variability in anticipated cash flows by changes in spot prices, the portion of the change in value of the futures due to changes in spot prices will exactly offset the change in expected cash flows due to a change in spot prices, discounted to present value. This portion of the change in value of the futures is therefore an effective hedge of the anticipated transaction, and is reflected in OCI. The change in the value of the futures contract due to the change in the difference between futures prices and spot prices will be excluded from determination of hedge effectiveness, and will be reflected in net income. The entire fair value of the futures contract will still be reflected as an asset or liability in the balance sheet. At the end of each accounting period, the following journal entry will be made to record the change in value of the futures contracts, and to apportion the change into OCI and net income. (The journal entries made at each balance sheet date will use the same accounts, but whether the entries to specific accounts are debits or credits will depend on the relative changes in futures and spot prices.)
Futures Contracts XX
OCI YY
Other Income ZZThe accounting for situations in which futures contracts are used as hedging instruments is illustrated in the fourth case, "C.L. Smith and Sons: Accounting for Futures Hedging Commodity Purchases and Sales."
The change in the futures contract value is affected by spot rate movements and futures price movements. If the Note Payable is refunded at spot rates, that portion of the hedge's value change that is attributable to spot rates should be perfectly effective in hedging the refunding cost at spot rates. The FASB reasons that such a perfect hedge should not have to be subject to quarterly effectiveness testing required of most hedges. That portion of a futures contract's value change that is attributable to the change in spot rates can be deferred in OCI as a perfectly effective hedge. The remaining portion of the value change impacted by futures price movements net of spot rate changes must be debited or credited to current earnings as opposed to OCI.
Question 15
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.
Note that the journal entries should follow the accounting suggested by Teets and Uhl in the previous question's hints. Initially assume that the discount rate used to discount the future cash flows back to a present value is zero. For example, note Example 2 beginning in Paragraph 111 on Page 61 of FAS 133. In particular, note the present value discussion in Paragraph 112. Initially, for the MarginOOPS case, you are to assume a zero percent discount rate. Later on the discount factor will be introduced in the case.
The journal entries are to be derived using the Exhibit 4 template. For the journal entries, you need only fill in the columns under the zero discount rate alternative. The discounting columns will be filled in in a later question.
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.
Update Warning: Since futures contracts are settled daily, a 0.0% discount rate should be used as illustrated in Example 7 of Appendix B in FAS 133. The illustration in Exhibit 4 of this case illustrates the discounting versus the non-discounting solutions. Professor Walter Teets sent me the following email message concerning his changing of the original answers in the Teet and Uhl case entitled "C.L. Smith and Sons: Accounting for Futures Hedging Commodity Purchases and Sales" at http://www.gonzaga.edu/faculty/teets/index0.html
| September 7, 2000 The error in our case is simply that the futures values (due to changes in either spot or futures prices) shouldn't be present valued, since there is daily settling up. But the (change in) values of the anticipated cash flows of the hedged item should be present valued, because there is usually no periodic settling of the cash flows associated with the hedged item. The change to the case is minor; the major point of the futures case is to show exclusion of the change in the difference between future and spot price from the determination of effectiveness. Present valuing the cash flow associated with the anticipated transaction, while not present valuing the futures (change in) value adds additional ineffectiveness to the hedging relation. Walter Teets at Gonzaga University |
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Question 16
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 hedging cash rolls in for BTS-Long futures contracts as interest rates rise and futures prices decline.. It rolls in for STB-Short 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. Acquisitions 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 1
7Hint: 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 .
Note: You do not have to actually make the IAS 39 journal entries. Merely describe the main changes that would have to be made in the Exhibit 4 journal entries.
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 18
What is the basic difference between the Cash Account and the Futures Margin Account?
In other words, is the Futures Margin Account a cash equivalent?
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.
Question 19
At long last we will drop the simplifying assumption of a zero discount rate and
make the MarginOOPS case more like Example 2 beginning in Paragraph 111 on Page
61 of FAS 133. FAS 133 requires that present values be computed
using appropriate discount rates.
Required: Fill in the last two columns of Exhibit 4 assuming a discount rate of 6.00% APR which translates to 0.016438356% daily. Use the daily rate. Note that the journal entries should follow the OCI accounting suggested by Teets and Uhl in the quote provided above. This makes sense since the case at hand does not assume daily settlements of the futures contracts. However, in real life, such contracts are settled daily and the discount rate should accordingly be set at zero.
Update Warning: Since futures contracts are settled daily, a 0.0% discount rate should be used as illustrated in Example 7 of Appendix B in FAS 133. The illustration in Exhibit 4 of this case illustrates the discounting versus the non-discounting solutions. Professor Walter Teets sent me the following email message concerning his changing of the original answers in the Teet and Uhl case entitled "C.L. Smith and Sons: Accounting for Futures Hedging Commodity Purchases and Sales" at http://www.gonzaga.edu/faculty/teets/index0.html
| September 7, 2000 The error in our case is simply that the futures values (due to changes in either spot or futures prices) shouldn't be present valued, since there is daily settling up. But the (change in) values of the anticipated cash flows of the hedged item should be present valued, because there is usually no periodic settling of the cash flows associated with the hedged item. The change to the case is minor; the major point of the futures case is to show exclusion of the change in the difference between future and spot price from the determination of effectiveness. Present valuing the cash flow associated with the anticipated transaction, while not present valuing the futures (change in) value adds additional ineffectiveness to the hedging relation. Walter Teets at Gonzaga University |
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.