Working Paper 283
CapIT Corporation Options: Hedging Strategies and Accounting Under SFAS 133/IAS 39 for Eurodollar Interest Rate Options to Cap Borrowing Rates 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 Options Case and its companion called FloorIT Bank Options Case are as follows:
To help students learn the rather complicated ways in
which premium quotations on the Eurodollar options trading markets, as reported in the
financial press, can be translated into alternatives to hedge variable interest rates.
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 options to cap or floor borrowing and lending rates. One question in each case asks
students to evaluate the advantages and disadvantages of options relative to other hedging
alternatives such as interest rate swaps and forward/futures contracts.
To help students learn how to distinguish the interest
rate caps and floors before and after premium costs are factored into
"effective" net rate calculations. Option premium rates listed daily on the Chicago Mercantile Exchange (CME) are
factored into effective rate calculations.
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 intrinsic values and time values of option premiums quoted as annual
percentage rates that must be translated into dollar values for loans having terms
different than one year. 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 CapIT Corporation had a forecasted transaction to borrow $25 million in three months at a variable rate. The CFO of CapIT, Todd Evert, commenced to worry about rising rates 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 Rate (LIBOR) stood at 5.18% on June 17. By September 17, it might well become very high as world governments strive to halt inflation. The CapIT Corporation forecasted transaction entailed borrowing $25 million at a negotiated rate of LIBOR+0.45% APR. This rate reduces to (LIBOR+45%)(3/12 yr) for the intended loan period from September 17 to December 17. Bankers generally prefer a (91/360 yr) reduction in pleace of (3/12 yr), but we will try to keep it a bit easier in this case with the (3/12 yr) reduction. The difference is generally insignificant.
The cost of an option in a trading market such as the Chicago Mercantile Exchange (CME) is called the "premium." The "underlying" of an interest rate option is usually some type of note having a principal amount referred to as the "notional." Call options give holders the option to purchase notes at contracted strike rates that translate into strike prices for notes. Put options give holders the option to sell notes at contracted strike rates that translate into strike prices for notes.
Always remember that as interest rates go up, fixed rate note prices fall in trading markets and vice versa. Eurodollar certificates are fixed rate notes. As a result, Eurodollar call options are "in-the-money" if spot (current) interest rates fall below strike rates. Eurodollar put options are "in-the-money" if spot rates rise above strike rates. The difference between a spot rate value and an option’s strike value (after translating strike rates into dollar values) is called the option’s "intrinsic value." Options may be valuable even if their intrinsic values are negative. The reason is the time value component equal to the difference between total value and intrinsic value. Time value tends to decrease as options approach expiration dates. The farther away the expiration date, the more time the option has to eventually attain positive intrinsic value. American-style options can be exercised whenever they are in-the-money, whereas European-style options cannot be exercised until the expiration date. Asian-style options compute the payoff based upon an average intrinsic value over time. Option holders do not incur a penalty if options are never exercised. The maximum loss is the premium paid up front. Option writers sell the options and receive the premiums, but they take on much greater risk than option holders. For example, if interest rates soar, the put option writer’s liability is unbounded in the sense that the option writer must settle the contracts at spot rates. If interest rates plunge, the put option writer’s gain is limited to the premium received. The put option holder’s potential for gain is unbounded, whereas the loss is always equal to the premium paid for the option.
Holders of call options gain from plunging spot rates, whereas holders of put options gain from soaring interest rates. Interest rate options are traded on in organized markets such as the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT). In some instances the option settlements require physical delivery of U.S. Treasury bills, U.S. Treasury notes or some other contracted delivery items such as municipal bonds. For example, the holder of a Eurodollar put option purchases a right to "put" an optioned item in the hands of the option writer at the strike price. In effect the put holder is guaranteed a selling price at the contracted strike price. Rising interest rates send the prices of the underlying notes plunging. At a certain point, the option holder can purchase notes at low spot prices and put (sell) these notes under the option contract at higher strike prices. Many investors purchase interest rate put options in pure speculation that interest rates are going to go up (thereby creating put option gains from falling underlying note prices). But instead of speculating, money borrowers may hedge against rising interest rates by purchasing interest rate put options to offset possible surges in lending rates. It is possible to set a cap on net expense such that when a borrowing interest rate soars above the interest rate cap, the gain from the put options exactly offset a loss from having to borrow money at a rate above the capped rate.
Put options make a nice hedge for borrowers like CapIT Corporation, because there is no risk in future interest rate movements. Put options need not be exercised if strike interest rates are lower than spot rates (such that optioned note prices are above market prices of the optioned notes). The maximum loss is the price (premium) of each option that is paid up front when option is purchased. Unlike forward contract or futures contract hedges, there is no risk of further losses in either a speculation or a hedge no matter what happens to interest rates.
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 and American style interest rate options that can be exercised at any time during the contract period. All option prices (premiums) moves in discrete "ticks" of 0.01 depicting 0.01% of the notional amount. 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 rate (APR). The Eurodollar notes on the CME are 90-day notes, such that options 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).
In summary, the cost of each Septermber put option on June 17,1999 can be calculated as follows:
$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
0.85 = premium listed on June 17, 1999 for a September
put option at a 9,450 strike price
85 ticks = put option premium scaled in terms of ticks
$2,125 = ($25)(85 ticks)
= ($2500)(0.85 listed premium on June 17 for a September put option)
= ($250,000)(0.85%)
The premium can be calculated as follows:
0.2125% = ($2,125 discount) / ($1,000,000 notional) rate for (3/12 yr)
0.85% APR = (0.2125%)(4 quarters of the year) rate for a full year
0.85 = (0.85%)(100) premium for a full year
Eurodollar interest-rate options are somewhat different from many other types of interest rate options in that they are settled net for cash without physical delivery of the underlying notes themselves. These are traded in the International Money Market (IMM) of the CME. This CapIT Corporation case focuses on the purchase of put options in the IMM. Put options are used by CapIT to hedge a forecasted transaction to borrow $25 million. Todd Evert decided on a put option having a strike price of 9,450 basis points which is equivalent to a strike rate of 5.50%. The put option is a "short position" on a futures contract to sell Eurodollars at any time between June 17 and September 17 at the strike price. If interest rates soar above the strike rate, the put option has positive intrinsic value that can be settled at any time for cash. If interest rates soar, the price of Eurodollars declines. In theory, CapIT could buy Eurodollar notes at cheap spot prices due to soaring interest rates and put (sell) them at high strike prices due to low contracted strike interest rates. What really happens, however, is that there is no physical moving of Eurodollars. The intrinsic value of the excess of the spot interest rate over the contracted strike rate is settled in cash whenever FloorIT elects to exercise the put option.
On June 17, Todd Evert purchased 25 September Eurodollar interest rate put options in order to place a cap on the September 17 borrowing rate. 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 put option, the option holder may acquire (buy) the note at a strike price based upon the corresponding strike rate of interest. Strike 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 strike price corresponding to the strike rate of interest.
_____________________________________________________________________________________
Insert Exhibit 1 About Here
_____________________________________________________________________________________
Student 1 Message
A message written by me to a student on February
26, 2000:
I think the confusion here lies in part do to the fact that interest rate option values are negatively correlated with interest rates. The option values always change with any movement in interest rates. Also remember that interest rate options are valued inversely with interest rates whereas wheat options are correlated positively with wheat prices.
Another source of confusion lies in comparing fixed versus variable rate notes. The values of fixed rate notes move with interest rate changes, whereas the values of variable rate notes remain constant when interest rates change. Eurodollar certificates (notes) are fixed rate notes such that their values vary with changes in interest rates. The values of options on those certificates also vary with interest rates.
A Eurodollar call option is an option to buy and a put option is an option to sell $1 million notional amounts of Eurodollar certificates. If interest rates plunge a call option goes in the money and a put option becomes worthless. If interest rates soar, a call option becomes worthless and a put option goes in the money. This is why the put option in the CapIT case settled in the money. In the CapIT case, the LIBOR increased over time.
When we are dealing in options for wheat, a put option's value rises when wheat prices plunge. But if we are dealing with interest rate options, a Eurodollar put option's value rises when interest rates soar. This is because Eurodollar put option values are negatively correlated with LIBOR. In order for a Eurodollar put option to settle in the money, LIBOR must rise to a point where the value of the put option exceeds the strike price (which is 9,450 basis points corresponding to 10,000 basis point less 9,450 = 550 basis points, or 5.50% in the CapIT Case).
When we are dealing in options for wheat, a call option's value rises when wheat prices soar. But if we are dealing with interest rate options, a Eurodollar call option's value rises when LIBOR plunges. This is because Eurodollar call option values are negatively correlated with interest rates. In order for a Eurodollar interest rate call option to settle in the money, LIBOR rates must plunge to a point where the value of the call option exceeds the strike price.
You must be clear about whether you are making reference to a note (the hedged item) or the derivative (the hedge). A $1,000 fixed rate bond will increase in market price if interest rates decline. It will sell for a premium. When interest rates increase, a fixed coupon bond will sell at a discounted price below $1,000. The same is true for a $25 million fixed rate note on the open market. The cash flows are fixed, so the value note's value moves up and down as interest rates change in the economy. It is possible to use a derivative (e.g., a futures contract or a forward contract) to hedge the fair value. Doing so, however, introduces cash flow risk that was nonexistent before the hedge. The derivative's value must move in the opposite direction as the value to hedge the value of a note or bond.
In contrast, a variable rate note or bond maintains a constant value in the market. But the cash flows (interest payments) vary with interest rate movements in the economy. If interest rates rise, the value of the note remains constant, but the cash flows increase (out from the debtor and into the hands of the investor). The CapIT Corporation intended to become a debtor for $25 million and wanted to cap the eventual interest expense of a forecasted transaction. The 25 put options did not lock in a rate (as could be done with forward or futures contracts), but they did cap the rate such that interest expense would never rise above an amount which you must compute in the case. Note, however, that the value of each put option is negatively correlated with LIBOR. If interest rates plunge, a Eurodollar put option will expire worthless. If interest rates soar, Eurodollar put options go into the money and settle for values above the strike price.
I hope this will clarify your thinking on this matter. For example, in your message below you state the following:
In our case, we are dealing with notes with variable, not fixed interest
rates. Therefore, as I understand it, the price of a $25 million note
will increase as interest rates go up (the face value stays the same,
but now we must pay more for out interest expense).In practice the "price" of the $25 million variable rate note will not change with interest rate movements. It would only change if the coupon rate was fixed. What varies, if the coupon rate is not fixed, is the cash flow (interest) on the $25 million. This is what the debtor is hedging with put options in the CapIT Case and what the investor is hedging with call options in the FloorIT Case.
I do not know that I ever said anything in class that was inconsistent with the above reasoning. If I said anything to mislead you, I hope that this message helps to set the record straight. If my reasoning above is muddled, please let me know immediately.
I always appreciate it when students send me email messages for clarification.
Thanks,
Dr J
Student 2 Message
It is easy to become confused about how strike prices relate to interest rates. Suppose the strike price is 9450 on the CME. This means that the strike price is 9450 basis points. This corresponds to a strike rate of 5.50% = (10000-9450)/10000. Now suppose the LIBOR spot rate on a given day is 4.50% corresponding to 9550 basis points. This relates to the following difference between spot minus strike:
(9550 Spot - 9450 strike) = +100 basis points = 100/10000 = +1.00% call
(10000 - 9450) - (10000 - 9550) = 9550 - 9450 = 100 basis points = 100/10000 = +1.00% call
(100% - 4.50% spot) - (100% - 5.50% strike) = 5.50% strike - 4.50% spot) = +1.00% call
The point I am trying to make is that the intrinsic value of a call option is the strike rate minus the spot rate even though the intrinsic value of a long position is really the spot (sale) value minus the strike (buy) value. The reason is that rates and values are negatively correlated.
For the put option, the calculations are as follows:
(9450 strike - 9550 spot) = -100 basis points = -100/10000 = -1.00% put
(10000 - 9550) - (10000 - 9450) = 9450 - 9550 = 100 basis points = -100/10000 = -1.00% put
(100% - 4.50% spot) - (100% - 5.50% strike) = 4.50% spot - 5.50% strike) = -1.00% put
The point I am trying to make is that the intrinsic value of a put option is the spot rate minus the strike rate even though the intrinsic value of a short position is really the strike (sale) value minus the spot (buy) value. The reason is that rates and values are negatively correlated.
I hope this helps!
Dr J
Case Questions (in black)
With Answers (in red)
(Students fill in the answers shown here in red.)
Strike Price Expressed as an APR % |
Interest Rate Cap Excluding Premium |
Cost of 25 Contracts |
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 |
Note that even though the Exhibit 1 strike prices pertain to intervals shorter than one year, they equate to an annual percentage rate (APR). For example, a strike 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
The cap rate is equal to 0.45% plus the strike price rate 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 strike prices in
Show all calculations that you place in the cells of
the above answer table.
[(0.25)($2500)(25 put contracts)] = $ 15,625 for a strike rate of (10,000 – 9,425)/100 = 5.75%
APR
[(0.85)($2500)(25 put contracts)] = $ 53,125 for a strike rate of
(10,000 – 9,450)/100 = 5.50% APR
[(2.30)($2500)(25 put contracts)] = $143,750
for a strike rate of (10,000 – 9,475)/100 = 5.25%
APR
[(4.45)($2500)(25 put contracts)] =
$278,125 for a strike rate of (10,000 –
9,500)/100 = 5.00% APR
[(6.90)($2500)(25 put contracts)] = $431,250
for a strike rate of (10,000 – 9,525)/100 = 4.75%
APR
[(9.40)($2500)(25 put contracts)] = $587,500
for a strike rate 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 strike rate = 5.75% APR = 9,425-strike
[(0.85%)($1,000,000)(3/12 yr)(25 put contracts)] = $ 53,125 for a
strike rate = 5.50% APR = 9,450-strike
[(2.30%)($1,000,000)(3/12 yr)(25 put
contracts)] = $143,750 for a strike rate = 5.25% APR =
9,475-strike
[(4.45%)($1,000,000)(3/12 yr)(25 put
contracts)] = $278,125 for a strike rate = 5.00% APR =
9,500-strike
[(6.90%)($1,000,000)(3/12 yr)(25 put
contracts)] = $431,250 for a strike rate = 4.75% APR
= 9,524-strike [(9.40%)($1,000,000)(3/12 yr)(25 put contracts)] = $587,500
for a strike rate = 4.50% APR = 9,550-strike
The effective cap rates are derived as follows:
9,425 put strike price cap rate = 5.75%
+0.45% + 0.25% premium = 6.45% APR effective rate
9,450 put strike price cap rate = 5.50%
+0.45% + 0.85% premium = 6.80% APR effective rate
9,475 put strike price cap rate = 5.25%
+0.45% + 2.30% premium = 8.00% APR effective rate
9,500 put strike price cap rate = 5.00%
+0.45% + 4.45% premium = 9.90% APR effective rate
9,525 put strike price cap rate = 4.75%
+0.45% + 6.90% premium = 12.10% APR effective rate
9,550 put strike price cap rate = 4.50%
+0.45% + 9.40% premium = 14.35% APR effective rate
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 rates 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 put 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 rate (APR). The Eurodollar notes on the CME are 90-day notes, such that options
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 options 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-strike price July put option, we find J = 0.10 = (0.10%)(100) in Exhibit 1. For a 9,450-strike price August option, we find A = 0.65 = (0.65%)(100). For a
9,500-strike 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 options purchased on June 17 expire in (1/12) of a year and the August options 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 rate borrowing planned for September 17. Assume Todd Evert decides to put a cap
on the variable rate by purchasing 25 September options having a strike 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 rate 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-strike price
= $ 9,375
Alternately, this can be computed with as the tick rate’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-strike price
= $ 9,375
Net interest on $25 million from September 17 to December 17 at 6.50 % spot rate + 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 rate)/4
= $425,000 for three months
What is the net borrowing rate 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 rate of 6.80%.
Question 4
Part A:
What portions of the put option’s 0.85% premium rate for June 17 in Exhibit 1 are intrinsic value rates
versus time value rates? Recall that on June 17, the spot LIBOR was 5.18%. CapIT chose the
5.50% strike rate 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
Part B:
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.
[(-0.32 intrinsic value rate)($2500)(25 contracts)]
= -$20,000 intrinsic value on June 17
[(+1.17 time value rate)($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 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 below.
Question 5
What is the balance sheet asset or liability for the "Options Contracts"
account's current value reported on August 31 for the 25 contracts purchased by
CapIT Corporation on June 17? Assume the 25 options 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 rate 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% 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
[(-0.32 intrinsic value rate)($2500)(25 contracts)] = -$20,000
intrinsic value on June 17
[(+1.17 time value rate)($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. Options 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.
---------------------------------------------------------------------------------------------------------------------------------
[(6.13% LIBOR – 5.50% strike)] = +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 rate)($2500)(25 contracts)] = +$39,375
intrinsic value on August 31
[(+0.26% time value rate)($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
---------------------------------------------------------------------------------------------------------------------------------
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 put 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-strike 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 rate of LIBOR+0.45% to a maximum fixed
(capped) rate 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 rate for reasons that will
become obvious when you graph the loan rates 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%.
Hint: The 5.51% spot rate is only one tick above the strike rate of 5.50% APR. Recall that the strike rate is 5.50% corresponding to the strike rate of 9,450 basis points. The cap rate from the Question 1 answer is 6.80% after factoring in the cost (premium) of the put option at the 9,450-strike price having a strike rate 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 put options
[ +($2,500)(0.85 cost of the options) ]
= +$
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 options are very slightly in-the-money, CapIT Corporation can borrow at the capped cost of $425,000.
Part B:
What is the net borrowing rate 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 rate of 6.80%.
Hint: The 5.49% spot rate is only one tick below the strike rate of 5.50% APR. Recall that the strike rate is 5.50% corresponding to the strike rate of 9,450 basis points. The cap rate from the Question 1 answer is 6.80% after factoring in the cost (premium) of the put option at the 9,450-strike price having a strike rate 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 put options
[ +($2,500)(0.85 cost of the options) ]
= +$
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 put options are slightly out of the money, CapIT Corporation gets a lower borrowing cost than the capped cost.
Part B:
What is the net borrowing rate 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 rate of 6.80%.
Hint: Recall that the strike rate is 5.50% corresponding to the strike rate of 9,450 basis points. The cap rate from the Question 1 answer is 6.80% after factoring in the cost (premium) of the put option at the 9,450-strike price having a strike rate 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 put options
[ +($2,500)(0.85 cost of the options) ]
= +$
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 put options are way out of the money, CapIT Corporation gets a significantly lower borrowing cost than the capped cost
Part B:
What is the net borrowing rate 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 rate of 6.80%.
Hint: The 9.00 % spot rate greatly exceeds the cap rate. Recall that the strike rate is 5.50% corresponding to the strike rate of 9,450 basis points. The cap rate from the Question 1 answer is 6.80% after factoring in the cost (premium) of the put option at the 9,450-strike price having a strike rate 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 put options
[ +($2,500)(0.85 cost of the options) ]
= +$
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 illustrates that the put options hedge all LIBOR rates above the capped rate 6.80% APR.
Part B:
What is the net borrowing rate 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 rate of 6.80%.
Question 13R = 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%
Hint: Recall that the strike rate is 5.50% corresponding to the strike rate of 9,450 basis points. The cap rate from the Question 1 answer is 6.80% after factoring in the cost (premium) of the put option at the 9,450-strike price having a strike rate 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 put options
[ +($2,500)(0.85 cost of the options) ]
= +$
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 rate, it really does not matter how high LIBOR soars above that point.
However, when the capping options go out-of-the-money (i.e., when LIBOR is less than
5.50%), CapIT Corporation can pay less than the capped rate. It must pay the capped amount
of $425,000, however, if LIBOR does not fall below the strike rate of 5.50%.
Part B:
What is the net borrowing rate 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 rate of 6.80%.
Hint: The net loan rate 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 strike price of 9,450 as shown in Exhibit 1. This results in a net loan rate that has the typical hedged "hockey stick" shape.
_____________________________________________________________________________________
Insert Exhibits 2 and 3 About Here
_____________________________________________________________________________________
Question 15
See Exhibit 3.
Part
B:Hint: Look at your answers to Question 1.
It appears that Todd Evert did not choose the best cap rate on
June 17. For a lower cost of $15,625, he could have obtained an effective 6.45% cap using
the 9,425 strike price corresponding a strike interest rate of 5.75% APR. His $53,125
choice ended up with an effective cap rate of 6.80% rather than 6.45%.
Question 16
The Exhibit
1 premium for the September put option using the
9,450-strike 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-strike price to become an effective cap rate 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 strike price cap rate = 5.75% +0.45% + 0.25%
premium = 6.45% APR
9,450 put strike price cap rate = 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-strike price would become as good for hedging purposes as the 9,425-strike 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 strike
rate of (10,000 – 9,450)/100 = 5.50% APR
[(0.50)($2500)(25 put contracts)] = $31,250 for a strike rate of
(10,000 – 9,450)/100 = 5.50% APR
Question 17
Part A:
If the September put option premium had been 0.40 instead of 0.85 for the
9,450-strike price in Exhibit 1, what would the optimal
choice have been for Todd Evert to cap the borrowing rate 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 rate is no longer obvious. The cost of the 9,450-strike price put option is compared with the 9,425 strike-price premium as follows:
[(0.25)($2500)(25 put contracts)] = $15,625 for a
strike rate of (10,000 – 9,425)/100 = 5.75% APR
[(0.40)($2500)(25 put contracts)] = $25,000 for a strike rate of
(10,000 – 9,450)/100 = 5.50% APR
Part B:
The effective cap rates are as follows for all Exhibit 1 alternatives are as follows:
9,425 put strike price cap rate = 5.75% +0.45% +
0.25% premium = 6.45% APR costs $ 15,625
9,450 put strike price cap rate = 5.50% +0.45%+ 0.40% premium = 6.35% APR costs $
25,000
9,475 put strike price cap rate = 5.25% +0.45% + 2.30% premium = 8.00% APR costs
$143,750
9,500 put strike price cap rate = 5.00% +0.45% + 4.45% premium = 9.90% APR costs
$278,125
9,525 put strike price cap rate = 4.75% +0.45% + 6.90% premium = 12.10% APR costs
$431,250
9,550 put strike price cap rate = 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 rate 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-strike price premium is only
$25,000 for a 0.40% premium having an effective cap of 6.35%. However, the Exhibit 1 9,450-strike 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.
The main advantage of options is that the risk is known and fixed at an amount equal to the initial level of investment in the purchase cost of the options 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 put options. 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. Options holders have no risks beyond the cost of the options. Purchases of hedging options are quick and easy if satisfactory deals are traded on open exchange systems such as the Chicago Board of Options Exchange.
Interest rate swaps have the advantage of both having a low
initial cost and fixed risk if a variable rate of interest is swapped for a fixed rate.
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.
_____________________________________________________________________________________
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 valueThe changes in time values and intrinsic values can be derived as follows:
[(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
[(-0.32 intrinsic value rate)($2500)(25 contracts)]
= -$20,000 intrinsic value on June 17
[(+1.17 time value rate)($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 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 below.
--------------------------------------------------------------------------------------------------------------------------------
[(5.10% LIBOR – 5.50% strike)] =
-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 rate)($2500)(25 contracts)]
= -$25,000 intrinsic value on June 30
[(+0.95 time value rate)($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)
= -$13,750 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
--------------------------------------------------------------------------------------------------------------------------------
[(5.38% LIBOR – 5.50% strike)] =
-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 rate)($2500)(25 contracts)]
= -$ 7,500 intrinsic value on July 31
[(+1.09 time value rate)($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
--------------------------------------------------------------------------------------------------------------------------------
[(6.13% LIBOR – 5.50% strike)] =
+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 rate)($2500)(25 contracts)]
= +$39,375 intrinsic value on August 31
[(+0.26 time value rate)($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
--------------------------------------------------------------------------------------------------------------------------------
[(0.00% total) ($2500)(25 contracts)] = +$0 intrinsic value + $0 time value = $0
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-strike
price
= $ 9,375
Note that under Paragraph 31 on Page 22 of SFAS 133 states that the net gain in OCI related to a hedging instrument should be reclassified into earnings when the hedged forecasted transaction affects earnings. In the case of this illustration, this means that the $9,375 will remain in OCI until some portion of the interest on the $25,000,000 debt is charged to earnings. For example, if 10% of the total note interest is charged to earnings, then 10% of the $9,375 would be taken from OCI and be credited to earnings. In this illustration, however, 100% of the note interest will be charged to earnings on December 17 prior to a December 31 closing. Hence, 100% of the OCI balance will be credited to earnings on December 17 as well.
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 = -$9,375 - (-$39,375)
=
+$30,000 Aug. 31-Sept. 17
Change in earnings =
-$36,875
= -$36,875 Aug. 31-Sept. 17
Change in total value = $62,500 settlement+ (-$55,625)
= +$ 6,875 Aug. 31-Sept. 17
--------------------------------------------------------------------------------------------------------------------------------
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-strike price
= $ 9,375
Alternately, this can be computed with the tick rate’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-strike price
= $ 9,375
Net interest on $25 million from September 17 to December 17 at 6.50 % spot rate + 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 rate)(3/12 yr)
= $425,000
for three months
Part B:
What portion of the option's net gain or loss is charged to earnings at the time of settlement versus the time at which the note interest is charged to earnings?
[Hint: See Paragraph 31 on Page 22 of SFAS 133.]
Note that under Paragraph 31 on Page 22 of SFAS 133 states that the net gain in OCI related to a hedging instrument should be reclassified into earnings when the hedged forecasted transaction affects earnings. In the case of this illustration, this means that the $9,375 will remain in OCI until some portion of the interest on the $25,000,000 debt is charged to earnings. For example, if 10% of the total note interest is charged to earnings, then 10% of the $9,375 would be taken from OCI and be posted to earnings. In this illustration, however, 100% of the note interest will be charged to earnings on December 17 prior to a December 31 closing. Hence, 100% of the OCI balance will be credited to earnings on December 17 as well.
Part
C:[($425,000/$25,000,000)(12/3 quarters) = 6.80% which is equal to the hedged floor rate 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. IAS 39 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 rate 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 put options
purchased by CapIT could be maintained on the books at historical cost ($53,125) until the
options 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 options as speculations. Put options
such as those illustrated 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
options remain from June 17 until September 17 at their historical cost of $90,625?
IAS 39 does require that derivative instruments be marked to market. There is no basic difference between the FASB and IAS 39 accounting for options..
Many banks and corporations argue that there
should be no mark-to-market adjustment of derivative financial instruments if
they are hedges that are expected to be held to maturity. They argue that,
in that instance, marking to market at interim points in time creates artificial
fluctuations in earnings that net to zero and are, therefore, misleading.
For a copper price swap analysis, see the Mexcobre Case..
For hedging via call options, see the FloorIT Bank Case.
For heding via Eurodollar futures contracts, see following cases: