Working Paper 285

CapIT Corporation Futures:   Hedging Strategies and Accounting Under SFAS 133/IAS 39 for Eurodollar Interest Rate Futures to Cap Borrowing prices 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 CapIT Corporation Futuress Case and its companion called FloorIT Bank Futures Case are as follows:

 

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Case Objectives Case Introduction Case Questions

Case Introduction
Note that all terminology definitions are given at
http://WWW.Trinity.edu/rjensen/acct5341/speakers/133glosf.htm#0000Begin

On June 17, 1999 CapIT Corporation had a forecasted transaction to borrow $25 million in on September 5 at a variable price. The CFO of CapIT, Todd Evert, commenced to worry about rising prices following the cessation of NATO bombing in Kosovo. Signs pointed to rising prices that might lead to upward movements in borrowing costs worldwide. By September 17 when the intended loan would take place, interest rates might be very high. The London Interbank Offered price (LIBOR) stood at 5.18% on June 17. By September 17, it might well rise to 7% or higher. The CapIT Corporation forecasted transaction entailed borrowing $25 million at a negotiated price of LIBOR+0.45% APR. This price reduces to (LIBOR+45%)(3/12 yr) for the intended loan period from September 17 to December 17.

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 prices for notes. futures give holders the option to sell notes at contracted settlement prices that translate into settlement prices for notes. 

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 ot lock in 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 intial 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 or 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 on June 17 for $12 and buys it on September 5 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 5.   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. 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 three-month portions of 0.01%. which are expressed as ($100)(3/12 yr) = $25 per tick. For example, a futures contract having a listed June 17 settlement of 94.56 will have a discounted transactions price of $986,400 = (100% - 94.56%)($1,000,000)(3/12 yr). On the CME, Eurodollar futres use the $25 tick illustrated in asomewhat more revealing way  is 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 futures contract on the CME
544 ticks = 10000 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 STB futures contract)
                 = $1,000,000 notional - ($250,000)(5.44%)
                = $1,000,000 notional - ($13,400 discount)

The yield can be calculated as follows:

$13,400 = $1,000,000 - $986.400 price of a June 17, 1999 for a September futures contract

          1.36%  = ($13,400 discount) / ($1,000,000 notional) yield for (3/12 yr)
  5.44% APR = (1.34%)(4 quarters of the year) yield for a full year.

Eurodollar interest-price futures are somewhat different 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 miumum margin.  Daily gains are credited to the investor's account, and daily losses are charged to it.  If the margin falls below the minumum threshold, the investor has to deposit more funds. 

Eurodollar futures are traded in the International Money Market (IMM) of the CME. This CapIT Corporation case focuses on sell-then-buy (STB) futures contracts to be used by CapIT to hedge a forecasted transaction to borrow $25 million.  Todd Evert decided on a June 17 settlement rate of  95.56 which is equivalent to a settlement yield of 5.44% APR. Thereby, CapIT took on a "short position" on a futures contract to buy Eurodollars at any time between June 17 and September 17 at the settlement price. If futures contract yield rates soar above the settlement yield, this STB futures contract has a plunging purchase price (and soaring yield) that can be settled at any time for cash.  In theory, CapIT has locked in the 5.44% borrowing rate that is the net rate between the eventual higher borrowing rate minus the gain rate on the hedging contracts. What really happens is that the net settlement of the a futures contract hedge will exactly offset the increase or decrease of the rates at which CapIT will borrow $25 million on September 5.   CapIT can close out the futures contract on September 5 even though the contract runs until September 17.

On June 17, Todd Evert purchased 25 September Eurodollar interest-futures in order to place a cap on the September 17 borrowing price. This hedge cost $53,125 using the quoted premiums on the Chicago Mercantile Exchange (CME) given in the Wall Street Journal. These premiums are reproduced in Exhibit 1 . In the case of a call option, the option holder may acquire (buy) the note at a settlement price based upon the corresponding settlement price of interest. settlement is the term since a deal has been "struck" according to terms of the contract. In the case of a put option, the holder may deliver (sell) the note at the settlement price corresponding to the settlement price of interest.

_____________________________________________________________________________________

Insert Exhibit 1 About Here
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Case Objectives Case Introduction Case Questions

Case Questions (in black) With Answers (in red)
(Students fill in the answers shown here in red.)

Question 1
Exhibit 1
from the June 17, 1999  Wall Street Journal contains two types of futures. On June 17, Todd Evert purchased 25 futures to cap the interest expense on the $25 million CapIT Corporation intends to borrow on September 17. Assume the note price is the September 17 spot LIBOR plus 0.45% APR. In other words, fill in the following table using Exhibit 1 and explain your calculations.

settlement price Expressed as an APR %

interest rate Cap Excluding Premium

Cost of 25 Contracts
(Aggregated Premium)

interest rate Cap Including Premium

5.75% APR

5.75%+0.45%=6.20%

$ 15,625

06.45% APR

5.50% APR

5.50%+0.45%=5.95%

$ 53,125

06.80% APR

5.25% APR

5.25%+0.45%=5.70%

$143,750

08.00% APR

5.00% APR

5.00%+0.45%=5.45%

$278,125

09.90% APR

4.75% APR

4.75%+0.45%=5.20%

$431,250

12.10% APR

4.50% APR

4.50%+0.45%=4.95%

$587,500

14.35% APR

  • Assume that 25 futures (contracts that each have a $1 million notional) are purchased on June 17 in order to hedge the borrowing price for the $25 million loan.

  • Note that even though the Exhibit 1 settlement prices pertain to intervals shorter than one year, they equate to an annual percentage price (APR). For example, a settlement price of 9,425 basis points is equivalent to an APR of (10,000-9,425)/100 = 5.75% APR.

  • For a September put premium P, the scaling factor is $2,500P in Exhibit 1. For example, a put option having a settlement price of 9,425 basis points costs $2,500P = ($2,500)(0.25) = $625 per contract. The premium for a settlement price of 9,450 basis points costs $2,500P = ($2,500)(0.85) = $2,125 per contract. Each contract has a $1,000,000 notional.

  • The cap price is equal to 0.45% plus the settlement price price adjusted for the cost (premium) of the option expressed as a percentage of the loan value. For example, the calculation is shown for you in the case of two settlement prices in Exhibit 1. The 9,425 settlement price is equivalent to (10,000-9,425)/100 = 5.75%. The borrowing cost at this settlement price is (5.75%+0.45%) = 6.20%. The cap price of a put option for the 9,425 settlement price is (5.75% settlement + 0.45% + 0.25% premium) = 6.45%. In your solutions, please express all prices in annualized APR terms until you actually compute the cash flows for three-month contracts. Each contract has a $1,000,000 notional.


Show all calculations that you place in the cells of the above answer table.

[(0.25)($2500)(25 put contracts)] = $   15,625 for a settlement price of (10,000 – 9,425)/100    = 5.75% APR
[(0.85)($2500)(25 put contracts)] = $  53,125 for a settlement price of (10,000 – 9,450)/100     = 5.50% APR

[(2.30)($2500)(25 put contracts)] = $143,750 for a settlement price of (10,000 – 9,475)/100     = 5.25% APR
[(4.45)($2500)(25 put contracts)]  = $278,125 for a settlement price of (10,000 – 9,500)/100      = 5.00% APR
[(6.90)($2500)(25 put contracts)] = $431,250 for a settlement price of (10,000 – 9,525)/100    = 4.75% APR
[(9.40)($2500)(25 put contracts)] = $587,500 for a settlement price of (10,000 – 9,550)/100    = 4.50% APR

It may be more revealing in terms of each option's $1,000,000 notional to compute the contract costs as follows:

[(0.25%)($1,000,000)(3/12 yr)(25 put contracts)] = $ 15,625 for a settlement price  = 5.75% APR  = 9,425-settlement
[(0.85%)($1,000,000)(3/12 yr)(25 put contracts)] = $ 53,125 for a settlement price  = 5.50% APR = 9,450-settlement

[(2.30%)($1,000,000)(3/12 yr)(25 put contracts)] = $143,750 for a settlement price = 5.25% APR = 9,475-settlement
[(4.45%)($1,000,000)(3/12 yr)(25 put contracts)] = $278,125 for a settlement price = 5.00% APR = 9,500-settlement
[(6.90%)($1,000,000)(3/12 yr)(25 put contracts)] = $431,250 for a settlement price = 4.75% APR = 9,524-settlement [(9.40%)($1,000,000)(3/12 yr)(25 put contracts)] = $587,500 for a settlement price = 4.50% APR = 9,550-settlement

The effective cap prices are derived as follows:

9,425 put settlement price cap price = 5.75% +0.45% + 0.25% premium =   6.45% APR effective price
9,450 put settlement price cap price = 5.50% +0.45% + 0.85% premium =   6.80% APR effective price
9,475 put settlement price cap price = 5.25% +0.45% + 2.30% premium =   8.00% APR effective price
9,500 put settlement price cap price = 5.00% +0.45% + 4.45% premium =   9.90% APR effective price
9,525 put settlement price cap price = 4.75% +0.45% + 6.90% premium = 12.10% APR effective price
9,550 put settlement price cap price = 4.50% +0.45% + 9.40% premium = 14.35% APR effective price

Explain the derivation of the "$2,500 scaling factor." In order to explain its derivation, think of the Exhibit 1 option premiums as annual percentage prices on $1,000,000 notional amounts. For example, a 0.85% APR put option premium for a September settlement translates to a dollar amount of (0.85%)($1,000,000) = $8,500 per year. However, the time period between June 17 and September 17 is only three months, reducing the premium cost to ($8,500)(3/12 yr) = $2,125 per call option contract. Hence, 25 contracts cost CapIT Corporation ($2,125)(25) = $53,125.

This question is answered as follows in the case itself. Each CME option contract’s price (premium) moves in discrete "ticks" of 0.01 depicting 0.01% of the notional amount. For a $1 million notional, the tick is equivalent, therefore, to $100 = ($1,000,000)(0.01%). The 0.01%, however, is an annual percentage price (APR). The Eurodollar notes on the CME are 90-day notes, such that futures premiums are based upon the three-month portions of 0.01%. For example, a put option having a listed premium of 0.85 will have a cost of $2,125 = (0.85%)($1,000,000)(3/12 yr). A somewhat more convenient way of calculating the premium is X = $2,500P where P is the quoted premium. For example, when P=0.85, the dollar cost of the Eurodollar interest rate option is $2,125 = ($2,500)(0.85). Different interest-rate futures such as a 13-week U.S. Treasury bill would base the calculation on 13 weeks rather than the three-month time span of a Eurodollar option.

Question 2
What are the scaling factors for July, August, and September put option having a premiums of J, A, and S respectively in Exhibit 1? For example, for a 9,425-settlement price July put option, we find J = 0.10 = (0.10%)(100) in Exhibit 1. For a 9,450-settlement price August option, we find A = 0.65 = (0.65%)(100). For a 9,500-settlement price September option, we find S = 4.45 = (4.45%)(100) in Exhibit 1. What are the corresponding scaling factors used to compute the put option costs as a function of J, A, or S values given in Exhibit 1?

The scaling factor is always the $2,500 = (.01)($1,000,000)(3/12 yr) even if the July futures purchased on June 17 expire in (1/12) of a year and the August futures expire in (2/12) of a year. The amount of time remaining until expiration does not affect the scaling factor used in converting quoted Eurodollar option premiums into dollar premiums. Let P depict a July (J), August (A), or September (S) price in Exhibit 1. The amount to be paid for the option is X=$2,500P in every case. When J=0.10 in Exhibit 1, the cost of the one-month option is $250=($2,500)(0.10). When A=0.65, the cost of the two-month option is $1,625=($2,500)(0.65). When S=4.45, the cost of the three-month option is $11,125=($2,500)(4.45).

What determines the scaling factor is the contracted time period of the underlying note. Eurodollar notes on the CME all have a three-month contracted time period. Hence, the scaling factor is based upon (3/12) of a year no matter whether the option expires in July, August, or September in Exhibit 1.

Question 3 
Suppose that on June 17, CapIT Corporation elects to cap the $25 million forecasted variable price borrowing planned for September 17. Assume Todd Evert decides to put a cap on the variable price by purchasing 25 September futures having a settlement price of 9,450 in
Exhibit 1. If LIBOR rises to a 6.50% APR on September 17, compute the September 17 cash settlement (positive or negative) for CapIT interest rate hedge of a borrowing of $25 million from September 17 to December 17 (when the loan is paid off). What is the three-month interest cost in total dollars if the variable loan price is specified at the September 17 LIBOR plus 0.45%? What is the net cost after these interest cash outflows are adjusted for the net profit of the put option hedge?

Hint: Multiply all interest calculations by (3/12) or divide by 4 for cash flow calculations for three-month intervals.

September 17 settlement if LIBOR= 6.50% becomes (6.50%-5.50%)($25m)(3/12 yr) =  $62,500
Less the June 17 cost (premium) for 25 hedging option contracts = -(0.85)($2,500)(25) =-$53,125
Net income on the 25 hedging option contracts having a 9,450-settlement price                      = $  9,375

Alternately, this can be computed with as the tick price’s annualized $10,000 premium scaling factor as follows:

September 17 settlement if LIBOR=6.50% becomes (6.50%-5.50%)($25m)(3/12 yr)  =  $62,500
Less the June 17 cost (premium) for 25 contracts = -(0.85%)($10,000)(25)(3/12 yr)    =  - 53,125
Net income on the 25 hedging option contracts having a 9,450-settlement price                     = $   9,375

Net interest on $25 million from September 17 to December 17 at 6.50 % spot price + 0.45% = $434,375

Net cost of hedged loan = $434,375 cost - $9,375 hedge       = $425,000 for three months
Proof calculation = ($25m)(6.80% cap price)/4                        = $425,000 for three months

What is the net borrowing price APR after the settlement of the 25 put hedging contracts are factored into the calculation based upon a September 17 LIBOR of 6.50%?

[($425,000/$25,000,000)(12/3 quarters) = 6.80% which is equal to the hedged cap price of 6.08%.

Question 4 
What portions of the put option’s 0.85% premium price for June 17 in Exhibit 1 are intrinsic value prices versus time value prices? Recall that on June 17, the spot LIBOR was 5.18%. CapIT chose the 5.50% settlement price corresponding to 9,450 basis points.

Hint: Intrinsic value is discussed in Bob Jensen’s SFAS 133 and IAS 39 Glossary. An illustration of intrinsic value versus time value accounting is given in Example 9 of SFAS 133, Pages 84-86, Paragraphs 162-164.

[(5.18% LIBOR – 5.50% strike)]     =   -0.32% intrinsic value portion of 0.85% June 17 premium
[0.85% total - (-0.32% intrinsic)]      = +1.17% positive time value portion of 0.85% June 17 premium


However, for purchased options, the intrinsic value cannot be negative, because the option holder can elect not to exercise the option.  Unlike forward and futures contracts, the option holder cannot be required to pour any money into the option contract beyond the amount of the initial premium.  Hence, the revised calculations are show below:

[(max of -0.32% or 0.00%)]             =   0.00% intrinsic value portion of 0.85% June 17 premium
[0.85% total - (-0.00% intrinsic)]      = +0.85% positive time value portion of 0.85% June 17 premium

What portions of the total cost (in dollars) of 25 put option contracts on June 17 are intrinsic value dollars versus time value dollars? Recall that each option has a $1,000,000 notional in Exhibit 1.

[(-0.00 intrinsic value rate)($2500)(25 contracts)]      =  $0 intrinsic value on June 17
[(+0.85 time value rate)($2500)(25 contracts)]          = +$53,125 time value on June 17
[(0.85 total) ($2500)(25 contracts)] = $0 intrinsic value + $53,125 time value = $53,125

Since the above intrinsic and time values are not recorded on the date of acquisition, the starting value in OCI = $0. There is no current earnings adjustment for time value on June 17. The Options Contracts account is debited for $53,125 and Cash is credited for $53,125. In subsequent calculations it will be assumed that time value is $53,125 for a plug into the equations

Question 5 
What is the balance sheet asset or liability for the Option account's current value reported on August 31 for the 25 contracts purchased by CapIT Corporation on June 17? Assume the 25 futures qualify as a cash flow interest rate cap hedge of the forecasted loan transaction's interest rate. Also assume SFAS 133 rules are in effect for valuing derivative financial instruments.

Hint: The spot premium value per put option contract is given near the bottom of Exhibit 1 as 0.89 for August 31. The spot LIBOR price is 6.13%.

The balance sheet value is to be marked to-market at $55.625 = ($2,500)(0.89)(25 contracts).

This represents an increase of $2,500 from $53,125 to $55,625 due to a spot premium increase from 0.85% to 0.89% between June 17 and August 31 using Exhibit 1 data.

Question 6 
Using
Exhibit 1 data, what is the balance sheet amount reported in other comprehensive income (OCI) on August 31 for the 25 contracts purchased on June 17 in Question 1? Assume the 25 contracts qualify as a cash flow interest rate cap hedge of the forecasted loan transaction's interest rate. Assume the SFAS 133 accounting standard is in effect.

Hint: Intrinsic value is discussed in Bob Jensen’s SFAS 133 and IAS 39 Glossary. An illustration of intrinsic value versus time value accounting is given in Example 9 of SFAS 133, Pages 84-86, Paragraphs 162-164.

[(5.18% LIBOR – 5.50% settlement)] = -0.32% intrinsic value portion of 0.85% June 17 premium
[0.85% total - (-0.32% intrinsic)]  = +1.17% positive time value portion of 0.85% June 17 premium

[(-0.32 intrinsic value price)($2500)(25 contracts)] =  -$20,000 intrinsic value on June 17
[(+1.17 time value price)($2500)(25 contracts)]     = +$73,125 time value on June 17
[(0.85 total) ($2500)(25 contracts)] = -$20,000 intrinsic value + $73,125 time value = $53,125

Since the above intrinsic and time values are not recorded on the date of acquisition, the starting value in OCI = $0. There is no current earnings adjustment for time value on June 17. futures Contracts is debited for $53,125 and Cash is credited for $53,125. In subsequent calculations it will be assumed that time value is $53,121 for a plug into the equations below.

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[(6.13% LIBOR – 5.50% settlement)] = +0.63% intrinsic value portion of 0.89% Aug. 31 premium
[0.89% total - (+0.63% intrinsic)] = +0.26% positive time value portion of 0.89% Aug. 31 premium

[(+0.63% intrinsic value price)($2500)(25 contracts)] = +$39,375 intrinsic value on August 31
[(+0.26% time value price)($2500)(25 contracts)]       = +$16,250 time value on August 31
[(0.89% total) ($2500)(25 contracts)] = +$39,375 intrinsic value + $16,250 time value = $55,625

Change in intrinsic value = +$ 9,844 - ($0)     = +$ 9,844 between June 17 and Aug. 31
Change in time value = +$45,781 – $53,125   =  -$ 7,344 between June 17 and Aug. 31
Change in total value = $55,625 - $53,125     = +$ 2,500 between June 17 and Aug. 31

Change in intrinsic value = +$39,375 - ($0)   = +$39,375 between June 17 and Aug. 31
Change in earnings = +$2,500 - (+$39,375)  = -$36,875 between June 17 and Aug. 31
Change in total value = $55,625 - $53,125    = +$  2,500 between June 17 and Aug. 31

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All of the $39,375 intrinsic value is reported as other comprehensive income (OCI) under SFAS 133 rules for this cash flow hedge using 25 call option contracts. The remainder of the increase in total value is the --$36,875 degredation of time value that is debited to current earnings (through Interest Expense).

[ $39,375 credit bal. in OCI + $16,250 time value = $55,625 option value on August 31].

Question 7 
Discuss the outcome of all transactions through December after Todd Evert’s decision to cap the hedge at a 9,450-settlement price. For example, what is the net cost of the hedged interest on $25 million if LIBOR rises to 10% on September 17? What is the net cost if LIBOR jumps to 12%?

Todd Evert decided to pay $53,125 on June 17 for the piece of mind of converting a variable loan price of LIBOR+0.45% to a maximum fixed (capped) price of 6.80%. If LIBOR takes a huge jump to 10.00%, the net interest cost would only be ($25m)(6.80)(3/12 yr) = $425,000. The hedged cost is fixed at $425,000 for any value of LIBOR above 5.50%, which is sometimes called the kink price for reasons that will become obvious when you graph the loan prices as a function of LIBOR movements. Thus the hedged cost is $425,000 for a 10.00% LIBOR, a 12.00% LIBOR, and a 6.80% LIBOR on September 17. It is not the cost when LIBOR is less than 6.80%.

Question 8 
What is the net cost of the hedged interest on $25 million if LIBOR is 5.51% on September 17.

Hint: The 5.51% spot price is only one tick above the settlement price of 5.50% APR. Recall that the settlement price is 5.50% corresponding to the settlement price of 9,450 basis points. The cap price from the Question 1 answer is 6.80% after factoring in the cost (premium) of the call option at the 9,450-settlement price having a settlement price of 5.50%.

[ +($25,000,000)(5.51% + 0.45%)(3/12 yr)      = +$372,500 interest cost on the loan
[ -($25,000,000)(5.51% - 5.50%)(3.12 yr)       = -$        625 settlement of the 25 futures contracts
[ +($2,500)(0.85 cost of the futures) ]               = +$  53,125 aggregate premiums on June 17

Net cost from all transactions = +$372,500 - $625 + $53,125  = $425.000
The capped borrowing cost = ($25,000,000)(6.80%)(3/12 yr) = $425,000

When the futures are very slightly in-the-money, CapIT Corporation can borrow at the capped cost of $425,000.

What is the net borrowing price APR after the settlement of the 25 put hedging contracts are factored into the calculation based upon a September 17 LIBOR of 5.51%?

[($425,000/$25,000,000)(12/3 quarters) = 6.80% which is exactly equal to the hedged cap price of 6.80%.

Question 9 
What is the net cost of the hedged interest on $25 million if LIBOR is 5.49% on September 17?

Hint: The 5.49% spot price is only one tick below the settlement price of 5.50% APR. Recall that the settlement price is 5.50% corresponding to the settlement price of 9,450 basis points. The cap price from the Question 1 answer is 6.80% after factoring in the cost (premium) of the call option at the 9,450-settlement price having a settlement price of 5.50%.

[ +($25,000,000)(5.49% + 0.45%)(3/12 yr)      = +$371,250 interest cost on the loan
[ -($25,000,000)(0 since LIBOR<5.50%)        =   -$           0 settlement of the 25 futures contracts
[ +($2,500)(0.85 cost of the futures) ]               = +$  53,125 aggregate premiums on June 17

Net cost from all transactions = +$371,250 - $0 + $53,125     = $424,375
Recall that the capped cost = ($25,000,000)(6.80%)(3/12 yr) = $425,000

When the futures are slightly out of the money, CapIT Corporation gets a lower borrowing cost than the capped cost.

What is the net borrowing price APR after the settlement of the 25 put hedging contracts are factored into the calculation based upon a September 17 LIBOR of 5.49%?

[($424,375/$25,000,000)(12/3 quarters) = 6.6790% which is slightly less than the hedged cap price of 6.80%.

Question 10 
What is the net cost of the hedged interest on $25 million if LIBOR is 4.00% on September 17?

Hint: Recall that the settlement price is 5.50% corresponding to the settlement price of 9,450 basis points. The cap price from the Question 1 answer is 6.80% after factoring in the cost (premium) of the call option at the 9,450-settlement price having a settlement price of 5.50%.

[ +($25,000,000)(4.00% + 0.45%)(3/12 yr)      = +$278,125 interest cost on the loan
[ -($25,000,000)(0 since LIBOR<5.50%)        =    -$           0 settlement of the 25 futures contracts
[ +($2,500)(0.85 cost of the futures) ]               = +$  53,125 aggregate premiums on June 17

Net cost from all transactions = +$278,125 - $0 + $53,125     = $331,250
Recall that the capped cost = ($25,000,000)(6.80%)(3/12 yr) = $425,000

When the futures are way out of the money, CapIT Corporation gets a significantly lower borrowing cost than the capped cost.

What is the net borrowing price APR after the settlement of the 25 put hedging contracts are factored into the calculation based upon a September 17 LIBOR of 4.00%?

[($331,250/$25,000,000)(12/3 quarters) = 5.30% which is well below the hedged cap price of 6.80%.

Question 11 
What is the net cost of the hedged interest on $25 million if LIBOR is soars to 9.00% on September 17?

Hint: The 9.00 % spot price greatly exceeds the cap price. Recall that the settlement price is 5.50% corresponding to the settlement price of 9,450 basis points. The cap price from the Question 1 answer is 6.80% after factoring in the cost (premium) of the call option at the 9,450-settlement price having a settlement price of 5.50%.

[ +($25,000,000)(9.00% + 0.45%)(3/12 yr)      = +$590,625 interest cost on the loan
[-($25,000,000)(9.00% - 5.50%)(3.12 yr)       =   -$218,750 settlement of the 25 futures contracts
[ +($2,500)(0.85 cost of the futures) ]               = +$  53,125 aggregate premiums on June 17

Net cost from all transactions = +$590,625 - $218,750 + $53,125 = $425,000
Recall that the capped cost = ($25,000,000)(6.80%)(3/12 yr)         = $425,000

This question illustprices that the futures hedge all LIBOR prices above the capped price 6.80% APR.

What is the net borrowing price APR after the settlement of the 25 put hedging contracts are factored into the calculation based upon a September 17 LIBOR of 9.00%?

[($425,000/$25,000,000)(12/3 quarters) = 6.80% which is exacly equal to the hedged cap price of 6.80%.

Question 12 
Compute value of the adjustment (A) in the equation below that derives the CapIT Corporation borrowing price whenever the futures are in the money:

R = LIBOR +    A % for LIBOR >5.50%
R = 6.80% for LIBOR <5.50%

R = LIBOR + 1.30% for LIBOR >5.50%
R = 6.80% for LIBOR <5.50%

Question 13 
What is the net cost of the hedged interest on $25 million if LIBOR is 8.00% on September 17? Given that it hedged its borrowing at a capped cost of $425,000, what does LIBOR have to be for CapIT Corporation to pay less than this capped price?

Hint: Recall that the settlement price is 5.50% corresponding to the settlement price of 9,450 basis points. The cap price from the Question 1 answer is 6.80% after factoring in the cost (premium) of the call option at the 9,450-settlement price having a settlement price of 5.50%.

[ +($25,000,000)(8.00% + 0.45%)(3/12 yr)      = +$528,125 interest cost on the loan
[ -($25,000,000)(8.00% - 5.50%)(3.12 yr)       =  -$156,250 settlement of the 25 futures contracts
[ +($2,500)(0.85 cost of the futures) ]              = +$   53,125 aggregate premiums on June 17

Net cost from all transactions = +$528,125 - $156,250 + $53,125                    = $425,000
This is identical to the effective capped cost = ($25,000,000)(6.80%)(3/12 yr) = $425,000

Since CapIT Corporation hedged at an effective 6.80% borrowing cap price, it really does not matter how high LIBOR soars above that point. However, when the capping futures go out-of-the-money (i.e., when LIBOR is less than 5.50%), CapIT Corporation can pay less than the capped price. It must pay the capped amount of $425,000, however, if LIBOR does not fall below the settlement price of 5.50%.

What is the net borrowing price APR after the settlement of the 25 put hedging contracts are factored into the calculation based upon a September 17 LIBOR of 8.00%?

[($425,000/$25,000,000)(12/3 quarters) = 6.80% which is exactly equal to the hedged cap price of 6.80%.

Question 14 
Draw a graph showing the loan price net of the hedging impact. In other words, graph the loan price up to the kink point and then show the capped price after the kink point. The graph’s abscissa should show possible values of the September 17 LIBOR ranging from 5.00% to 7.000%. The graph’s ordinate should show the net loan price.

Hint: The net loan price will be linear (i.e., LIBOR+0.45%) up to the kink point when it becomes flat at the capped interest rate resulting from the purchase of 25 put option contracts on June 17 at a settlement price of 9,450 as shown in Exhibit 1. This results in a net loan price that has the typical hedged "hockey stick" shape.

_____________________________________________________________________________________

                                                         Insert Exhibits 2 and 3 About Here
_____________________________________________________________________________________

 

Question 15 
CapIT Corporation may have chosen any of the available settlement prices shown for futures in
Exhibit 1. Draw a graph showing the loan prices net of the hedging impact for September futures having settlement prices of 9,425 versus 9,450 versus 9,475 basis points. In other words, graph the loan prices up to the kink points and then show only the capped prices after the kink points. The graph’s abscissa should show possible values of the September 17 LIBOR ranging from 3.00% to 10.00%. The graph’s ordinate should show the net loan prices of the three settlement price choices.

See Exhibit 3.

Based upon the outcomes in the graph, does it appear that Todd Evert made an optimal hedge for CapIT Corporation?

Hint: Look at your answers to Question 1.

It appears that Todd Evert did not choose the best cap price on June 17. For a lower cost of $15,625, he could have obtained an effective 6.45% cap using the 9,425 settlement price corresponding a settlement interest rate of 5.75% APR. His $53,125 choice ended up with an effective cap price of 6.80% rather than 6.45%.

Question 16 
The
Exhibit 1 premium for the September put option using the 9,450-settlement price is 0.85% that translates into a $53,125 cost of 25 hedging contracts on June 17. What would the market premium in Exhibit 1 have to have been for the 9,450-settlement price to become an effective cap price of 6.45%? In that circumstance, how much would the hedge cost have to be in lieu of the $53,125 cost actually paid by CapIT Corporation on June 17?

9,425 put settlement price cap price = 5.75% +0.45% + 0.25% premium  = 6.45% APR
9,450 put settlement price cap price = 5.50% +0.45% + 0.50% premium = 6.45% APR

The market set the premium at 0.85% APR. This would have to fall to 0.50% if the 9,450-settlement price would become as good for hedging purposes as the 9,425-settlement price. If the market price fell to 0.50%, the hedging cost would fall from $53,125 to $31,250 as computed below:

[(0.85)($2500)(25 put contracts)] = $53,125 for a settlement price of (10,000 – 9,450)/100 = 5.50% APR
[(0.50)($2500)(25 put contracts)] = $31,250 for a settlement price of (10,000 – 9,450)/100 = 5.50% APR

Question 17 
If the September put option premium had been 0.40 instead of 0.85 for the 9,450-settlement price in
Exhibit 1, what would the optimal choice have been for Todd Evert to cap the borrowing price on the $25 million loan? Consider both the choice ex ante on June 17 and outcome ex post given the September 17 LIBOR of 6.50% APR.

Hint: Review your answers to Question 1.

Since interest rates are uncertain, the "optimal" cap price is no longer obvious. The cost of the 9,450-settlement price put option is compared with the 9,425 settlement-price premium as follows:

[(0.25)($2500)(25 put contracts)] = $15,625 for a settlement price of (10,000 – 9,425)/100 = 5.75% APR
[(0.40)($2500)(25 put contracts)] = $25,000 for a settlement price of (10,000 – 9,450)/100 = 5.50% APR

The effective cap prices are as follows for all Exhibit 1 alternatives are as follows:

9,425 put settlement price cap price = 5.75% +0.45% + 0.25% premium = 6.45% APR costs $ 15,625
9,450 put settlement price cap price = 5.50% +0.45%+ 0.40% premium = 6.35% APR costs $ 25,000
9,475 put settlement price cap price = 5.25% +0.45% + 2.30% premium = 8.00% APR costs $143,750
9,500 put settlement price cap price = 5.00% +0.45% + 4.45% premium = 9.90% APR costs $278,125
9,525 put settlement price cap price = 4.75% +0.45% + 6.90% premium = 12.10% APR costs $431,250
9,550 put settlement price cap price = 4.50% +0.45% + 9.40% premium = 14.35% APR costs $587,500

In this revised example, CapIT Corporation can get a 6.45% effective borrowing cap at the lowest June 17 cost of $15,625. However, it can get a lower effective cap price of 6.35% if it is willing to pay $25,000. The choices are thus to either have the lowest cap or the lowest cost. We need to know more about the probabilities of LIBOR movements after June 17 to assess optimality ex ante.

It is impossible to choose the "optimal" ex ante decision when the 9,450-settlement price premium is only $25,000 for a 0.40% premium having an effective cap of 6.35%. However, the Exhibit 1 9,450-settlement price was actually $53,125 from a 0.85% premium and an effective cap of 6.80%, Todd Evert made a poor ex ante choice on June 17. The 9,425-price is always better given the CME market premiums in Exhibit 1.

Question 18 
Hedging a borrowing price via a put option is only one of several alternatives for hedging a borrowing price. Other alternatives include interest rate swaps and interest rate forwards and futures. What is the main advantage of futures in hedging stpricegies?

The main advantage of options 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 purchased 25 put contracts for $53,125 on June 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.  An illustration of such risks is given in the MarginOOPS Bank Case.

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. On June 17, CapIT has no interest payments to swap.

Question 19 
Given the premium values at the bottom of
Exhibit 1, show the journal entries that are required under SFAS 133 and  IAS 39 for June 17, June 30, July 31, and September 17. Assume the books are closed at the end of each calendar year.

_____________________________________________________________________________________

                                                                 Insert Exhibit 4 About Here
_____________________________________________________________________________________

When solving this part of the case, it is best to compute the value of the derivative instruments (25 option contracts) and then partition this value into intrinsic value versus time value components. Readers are referred to Example 9 of SFAS 133, Pages 84-86, Paragraphs 162-164. Readers may also want to look up key terms in Bob Jensen's SFAS 133 and IAS 39 Glossary.

Using the hypothetical value changes at the bottom of Exhibit 1, the hedging contract value can be derived as shown below:

[(0.85% spot premium on June 17)($2500)(25 contracts) = $53,125 asset value
[(0.55% spot premium on June 30)($2500)(25 contracts) = $34,375 asset value
[(0.97% spot premium on July 31)($2500)(25 contracts)  = $60,625 asset value
[(0.89% spot premium on Aug. 31)($2500)(25 contracts) = $55,625 asset value
[(0.00% spot premium on Sep. 17)($2500)(25 contracts) = $          0 asset value

The changes in time values and intrinsic values can be derived as follows:

[(5.18% LIBOR – 5.50% settlement)]     =   -0.32% intrinsic value portion of 0.85% June 17 premium
[0.85% total - (-0.32% intrinsic)]      = +1.17% positive time value portion of 0.85% June 17 premium

[(-0.32 intrinsic value price)($2500)(25 contracts)]      = -$20,000 intrinsic value on June 17
[(+1.17 time value price)($2500)(25 contracts)]          = +$73,125 time value on June 17
[(0.85 total) ($2500)(25 contracts)] = -$20,000 intrinsic value + $73,125 time value = $53,125

Since the above intrinsic and time values are not recorded on the date of acquisition, the starting value in OCI = $0. There is no current earnings adjustment for time value on June 17. The futures Contracts account is debited for $53,125 and Cash is credited for $53,125. In subsequent calculations it will be assumed that time value is $53,125 for a plug into the equations below.

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[(5.10% LIBOR – 5.50% settlement)]     =   -0.40% intrinsic value portion of 0.55% June 30 premium
[0.55% total - (-0.4000% intrinsic)]  = +0.95% positive time value portion of 0.55% June 30 premium

[(-0.40 intrinsic value price)($2500)(25 contracts)]      = -$25,000 intrinsic value on June 30
[(+0.95 time value price)($2500)(25 contracts)]          = +$59,375 time value on June 30
[(0.55 total) ($2500)(25 contracts)] = -$25,000 intrinsic value + $59,375 time value = $34,375

Change in intrinsic value = -$25,000 - ( -$20,000)      = -$  5.000 between June 17 and June 30
Change in time value = +$59,375 - (+$73,125)          = -$13,500 between June 17 and June 30
Change in total value = $34,375 - $53,125                 = -$18,750 between June 17 and June 30

Change in OCI = -$25,000 - (-$0)                    =   -$25,000 between June 17 and June 30
Change in earnings = -$18,750 - (-$25,000)   = +$   6,250 between June 17 and June 30
Change in total value = $34,375 - $53,125     = -$18,750 between June 17 and June 30

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[(5.38% LIBOR – 5.50% settlement)]     =   -0.12% intrinsic value portion of 0.97% July 31 premium
[0.97% total - (-0.12% intrinsic)]      = +1.09% positive time value portion of 0.97% July 31 premium

[(-0.12 intrinsic value price)($2500)(25 contracts)]      =  -$ 7,500 intrinsic value on July 31
[(+1.09 time value price)($2500)(25 contracts)]          = +$68,125 time value on July 31
[(0.97 total) ($2500)(25 contracts)] = -$7,500 intrinsic value + $68,125 time value = $60,625

Change in intrinsic value = -$ 7,500 - (-$25,000)      = +$17,500 between June 30 and July 31
Change in time value = +$68,125 - (+59,375)          = +$  8,750 between June 30 and July 31

Change in total value = $60,625 - $34.375               = +$26,250 between June 30 and July 31

Change in OCI = -$ 7,500 - (-$25,000)                 = -$17,500 between June 30 and July 31
Change in earnings = +$26,250 - (-$17,500)        = -$  8,750 between June 30 and July 31
Change in total value = $60,625 - $34.375           = +$26,250 between June 30 and July 31

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[(6.13% LIBOR – 5.50% settlement)]     = +0.63% intrinsic value portion of 0.89% August 31 premium
[0.89% total - (+0.63% intrinsic)]     = +0.26% positive time value portion of 0.89% August 31 premium

[(+0.63 intrinsic value price)($2500)(25 contracts)]      =  +$39,375 intrinsic value on August 31
[(+0.26 time value price)($2500)(25 contracts)]           =  +$16,250 time value on August 31
[(0.89 total) ($2500)(25 contracts)] = +$39,375 intrinsic value + $16,250 time value = $55,625

Change in intrinsic value = +$39,375 - ( -$ 7,500)      =  +$46,875 between July 31 and August 31
Change in time value = +$16,250 - (+$68,125)          =   -$51,875 between July 31 and August 31
Change in total value = $55,625 - $60,625                 =    -$  5,000 between July 31 and August 31

Change in OCI = +$39,375 - ( -$ 7,500)                = +$46,875 between July 31 and August 31
Change in earnings = -$ 5,000 - (+$46,875)          =   -$51,875 between July 31 and August 31
Change in total value = $55,625 - $60,625            =  -$   5,000 between July 31 and August 31

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[(0.00% total) ($2500)(25 contracts)] = +$0 intrinsic value + $0 time value = $0

Change in intrinsic value = +$0 - (+$39,375)            =  -$39,375 between Aug. 31 and Sept. 17
Change in time value = +$0 - (+$16,250)                 =   -$16,250 between Aug. 31 and Sept. 17
Change in total value = +$0 - (+55,625)                  =   -$55,625 between Aug. 31 and Sept. 17

Change in OCI = $0 - (+$39,375)                                                         = -$39,375 Aug. 31-Sept. 17
Change in earnings = $62,500 settlement - $55,625 bal. - (-$50,000) =   +$56,875 Aug. 31-Sept. 17
Change in total value = +$0 - (-$55,625)                                            =   +$55,625 Aug. 31-Sept. 17

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September 17 settlement if LIBOR= 6.50% becomes (6.50%-5.50%)($25m)(3/12 yr)      =  $62,500
Less the June 17 cost (premium) for 25 hedging option contracts = -(0.85)($2,500)(25)      = - 53,125
Net income on the 25 hedging option contracts having a 9,450-settlement price                          =   $  9,375

Alternately, this can be computed with the tick price’s annualized $10,000 premium scaling factor as follows:

September 17 settlement if LIBOR=6.50% becomes (6.50%-5.50%)($25m)(3/12 yr)       = $62,500
Less the June 17 cost (premium) for 25 contracts = -(0.85%)($10,000)(25)(3/12 yr)          = -53,125
Net income on the 25 hedging option contracts having a 9,450-settlement price                          = $  9,375

Net interest on $25 million from September 17 to December 17 at 6.50 % spot price + 0.45% = $434,375

Net cost of hedged loan = $434,375 cost - $9,375 hedge      = $425,000 for three months
Proof calculation = ($25m)(6.80% cap price)(3/12 yr)             = $425,000 for three months

What is the net borrowing price APR after the settlement of the 25 put hedging contracts are factored into the calculation based upon a September 17 LIBOR of 6.50%?

[($425,000/$25,000,000)(12/3 quarters) = 6.80% which is equal to the hedged floor price of 6.80%

Question 20 
The accounting in Exhibit 4 is in conformance with SFAS 133 rules that require splitting changes in option values between Other Comprehensive Income (for changes in intrinsic value) and current income (for changes in time value). How would the journal entries change to conform to  IAS 39 of the International Accounting Standards Committee (IASC)?

Hint: See Paul Pacter's commentary at http://www.iasc.org.uk/news/cen8_142.htm . You can also read more of Paul Pacter's comments at http://www.trinity.edu/rjensen/acct5341/speakers/pacter.htm .

The only change is that all amounts recorded to OCI in Exhibit 4 would instead be combined with Interest Expense (Revenue) amounts. SFAS 133 does not have an OCI requirement comparable to that 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 21 
It was stressed initially that the $25 million loan was a "forecasted transaction." How would the journal entries change if there was a "firm commitment" for CapIT to borrow the $25 million on September 17? Is the distinction between firm commitments versus forecasted transactions as relevant on the international   IAS 39 standard as it is in the U.S. SFAS 133 standard?

Hint; The terms "forecasted transaction" and "firm commitment" 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 .

Paragraph 540 on Page 244 of SFAS 133 defines a "firm commitment" as follows:

An agreement with an unrelated party, binding on both parties and usually legally enforceable, with the
following characteristics:

a. The agreement specifies all significant terms, including the quantity to be exchanged, the fixed
price
, and the timing of the transaction. The fixed price may be expressed as a specified amount of
anentity's functional currency or of a foreign currency. It may also be expressed as a specified
interest rate or specified effective yield.

b. The agreement includes a disincentive for nonperformance that is sufficiently large to make
performance probable
.

The key is the term "fixed price." Even if CapIT Corporation signed an iron-clad contract to borrow $25 million on September 17, the variable price of LIBOR+0.45% is not a "fixed price." But if the contract were to be rewritten at a fixed price, there would be no uncertain interest rate to hedge. If the transaction is re-written to be a firm commitment as defined above, the only hedge accounting allowed for any firm commitment is a fair value hedge rather than a cash flow hedge.

Cash flow hedges are only allowed for forecasted transactions. If CapIT instead had a firm commitment to borrow the $25 million on September 17, all entries to OCI in Exhibit 4 would be transferred to Interest Expense (Revenue) or some other current earnings account. Changes in intrinsic value may not be placed in OCI when there is a firm commitment. The FASB reasoned that the transaction is effectively consummated when there is a firm commitment and all gains and losses should be recognized in the current period. Only when the transaction is not effectively consummated (by being only a forecasted transaction that can be gotten out of a little or no cost) can gains and losses be "deferred" in OCI until the transaction actually takes place on September 17.

Since the IASC does not allow an OCI account in IAS 39, forecasted transactions and firm commitments are treated alike in the international standard. This is not the case in the United States, however, since SFAS 133 will allow credits to OCI for the intrinsic value changes of forecasted cash flows.

One difference that is sometimes overlooked in IAS 39 international rules is that some fair value and forecasted transactions hedges do not have to be adjusted to fair value if they qualify as "held-to-maturity" financial instruments. In that case, the futures purchased by CapIT could be maintained on the books at historical cost ($53,125) until the futures are settled at the September 17 maturity date. SFAS 133 requires that they be marked-to-market as derivative financial instruments whether or not they qualify as hedges.

Question 22 
CapIT Corporation has a policy of never investing in futures as speculations. futures such as those illustpriced in this case are always "held to maturity" up to the time the hedged loan transpires. Todd Evert argued that the  IAS 39 does not require adjusting derivatives to current value if they are intended to be held to maturity. Under IAS 39, should the Exhibit 4 journal entries be changed so that the futures remain from June 17 until September 17 at their historical cost of $90,625?

IAS 39 does not allow derivative financial instruments to be maintained at historical cost if the investor is not reasonably certain to recover the initial cost. In the case of 25 futures on a forecasted loan transaction, there are all sorts of uncertainties. First and foremost, there is the uncertainty that the forecasted borrowing will never transpire. If that happens, CapIT Corporation ends up with having to take whatever speculative gain or loss it gets when the option contracts are settled. There is no assurance that interest savings from a variable price loan will cover the cost of the futures if the loan does not transpire.

In my viewpoint, the IAS 39 rule applies more to situations where there is little or no market risk. For example, in an interest rate swap, the initial investment is usually zero. If the investor has a policy of holding such swaps to maturity accompanied by a track record of living up to this policy, a case can be made for not adjusting the swaps to market value during the term of the swap. In fact, I have argued elsewhere that adjusting such swaps to fair value creates misleading fluctuations in assets and liabilities. But this argument does not extend to futures contracts used to hedge forecasted transactions.

 

For a copper price swap analysis, see the Mexcobre Case..

For hedging via futures contracts, see the FloorIT Bank Case.