Working Paper 284

FloorIT Bank **Options Case**:
Hedging Strategies and Accounting Under SFAS 133/IAS 39 for
Eurodollar Interest Rate **Options** to Floor Lending Rates on
Forecasted Loan Transactions

**Bob
Jensen** at **Trinity
University
**Terminology is Defined in Bob Jensen's Bob
Jensen’s SFAS 133 and IAS 39 Glossary

**Case Objectives**

The broad objectives of this FloorIT Bank Options Case and its companion called the CapIT Corporation Options Case are as follows:

- To help students learn the 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 FloorIT Bank had a forecasted transaction to lend $25 million in three months at a variable rate. The CFO of FloorIT, Pete Boniff, commenced to worry about falling rates following the cessation of NATO bombing in Kosovo. Signs pointed to rising prices that might lead to upward movements in lending costs worldwide. By September 17 when the intended loan would take place, interest rates might be very low. The London Interbank Offering Rate (LIBOR) stood at 5.18% on June 17. By September 17, it might well fall if world governments seek to stimulate their economies with abnormally low interest rates. The FloorIT Bank forecasted transaction entailed lending $25 million at a negotiated rate of LIBOR+0.45% APR. This rate reduces to (LIBOR+0.45%)(3/12 yr) for the intended loan period from September 17 to December 17. Bankers generally prefer a (91/360 day) reduction in place 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, note prices fall in trading markets and
vice versa. As a result, call options are "in-the-money" if spot (current)
interest rates fall below strike rates. 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, if a call option for U.S. Treasury notes is in-the-money, the call option holder might "call" for contracted delivery (from the option writer) of notes having a smaller strike prices (due to a higher strike interest rates under the option contract) than the higher spot prices caused by drops in interest rates in the current market The option holder may then sell the "called" notes at the higher spot prices for a profit. Many investors purchase interest rate calls in pure speculation that interest rates are going to go down (thereby creating call option gains from a rising note prices in the open market). But instead of speculating. money lenders may hedge against falling interest rates by purchasing interest rate call options to offset possible declines in lending rates. It is possible to set a minimum floor on net revenue such that when lending interest rates drop below the floor interest rates, the gains from the "called" options exactly offset losses from having to lend below floor rates.

Call options make a nice hedge for money lenders such as FloorIT Bank, because there is no risk due to uncertain future movements in interest rates. Call options need not be exercised if strike interest rates are lower than spot rates (such that note "call" purchase prices are above spot market selling prices). 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 future 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 Chicago Mercantile Exchange (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 CME options prices (premiums) move 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 call option having a listed premium of 1.45 will have a cost of $3,625 = (1.45%)($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=1.45, the dollar cost of the Eurodollar interest rate option is $3,625 = ($2,500)(1.45). 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.

In summary, the cost of each September call 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

1.45 = premium listed on June 17, 1999 for a September call option at a 9,450 strike price 145 ticks = call option premium scaled in terms of ticks

$3,625 =

($25)(145 ticks)

=($2500)(1.45 listed premium on June 17 for a September call option)

=($250,000)(1.45%)

The premium can be calculated as follows:

0.3625% = ($3,625 premium) / ($1,000,000 notional) rate for (3/12 yr)

1.45% APR = (0.3625%)(4 quarters of the year) premium rate for a full year

1.45 = (1.45%)(100) premium for a full year

Eurodollar interest-rate options are somewhat different in that they can be settled net
for cash and need not require physical delivery notes themselves. These are traded in the
International Money Market (IMM) of the CME. This FloorIT Bank case focuses on the
purchase of call options in the IMM. Call options are used by FloorIT to hedge a
forecasted transaction to borrow $25 million. Pete Boniff decided on a call option having
a strike price of 9,450 basis points which is equivalent to a strike rate of 5.50%. The
call option is a "long position" on a futures contract to acquire Eurodollars at
any time between June 17 and September 17 at the strike price. If interest rates plunge
below the strike rate, the call option has positive intrinsic value that can be settled at
any time (as an American-style option) for cash. If interest rates fall, the price of
Eurodollars declines. __In theory, FloorIT could call (buy) "cheap" Eurodollars
at high contracted strike interest rates and later sell them for soaring prices due to
plunging spot 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 call option.

On June 17, Pete Boniff purchased 25 September Eurodollar interest-rate call options in
order to place a floor on the September 17 lending rate. This hedge cost $90,625 using the
quoted premiums on the CME given in the *Wall Street
Journal*. These premiums are reproduced in **Exhibit
1** of this case. In the case of a call 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 call option, the holder may call (purchase) 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 value:

(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%callThe point I am trying to make is that the intrinsic value of a

call optionis thestrike rate minus the spot rateeven 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% putThe point I am trying to make is that the intrinsic value of a

put optionis thespot rate minus the strike rateeven 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.)

**Question 1
** Part A:

Strike Price Expressed as an APR %

Interest Rate Floor Excluding Premium

Cost of 25 Contracts

(Aggregated Premium)Interest Rate Floor Including Premium

5.75% APR

5.75%+0.45%=6.20%

$206,250

02.90% APR

5.50% APR

5.50%+0.45%=5.95%

$ 90,625

04.50% APR

5.25% APR

5.25%+0.45%=5.70%

$ 25,000

05.30% APR

5.00% APR

5.00%+0.45%=5.45%

$ 6,250

05.35% APR

- Assume that 25 options (contracts that each have a $1 million notional) are purchased on
June 17 in order to hedge the lending rate for the $25 million loan.

- 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 call premium P, the scaling factor is $2,500P in
**Exhibit 1**. For example, a call option having a strike price of 9,425 basis points costs $2,500P = ($2,500)(3.30) = $8,250 per contract. The premium for a strike price of 9,450 basis points costs $2,500P = ($2,500)(1.45) = $3,625 per contract. Each contract has a $1,000,000 notional.

- The floor 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
**Exhibit 1**. The 9,425-strike price is equivalent to (10,000-9,425)/100 = 5.75%. The lending rate at this strike price is (5.75%+0.45%) = 6.20%. The floor rate of a call option for the 9,425-strike price is (5.75% strike + 0.45% + 0.25% premium) = 6.45%. In your solutions, please express all rates in annualized APR terms until you actually compute the cash flows for three-month contracts. Each contract has a $1,000,000 notional.

Part B:

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

[(3.30)($2500)(25 **call** contracts)] = $206,250** **for a strike rate of (10,000
– 9,425)/100 = **5.75%** APR

[(1.45)($2500)(25 **call** contracts)] = $ 90,625 for a strike rate of (10,000 –
9,450)/100 = **5.50%** APR

[(0.40)($2500)(25 **call** contracts)] = $ 25,000 for a strike
rate of (10,000 – 9,475)/100 = **5.25**% APR

[(0.10)($2500)(25 **call** contracts)] = $ 6,250 for
a strike rate of (10,000 – 9,500)/100 = **5.00%** 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%)($1,000,000)(3/12 yr)(25 **call** contracts)] = **$
15,625**** **for a strike rate = **5.75%** APR = 9,425-strike

[(1.45%)($1,000,000)(3/12 yr)(25 **call** contracts)] =** $ 53,125** for a
strike rate = **5.50%** APR = 9,450-strike

[(2.30%)($1,000,000)(3/12 yr)(25 **call** contracts)] =** $143,750** for a
strike rate =** 5.25%** APR = 9,475-strike

[(4.45%)($1,000,000)(3/12 yr)(25 **call** contracts)] = **$278,125** for a
strike rate = **5.00%** APR = 9,500-strike

[(6.90%)($1,000,000)(3/12 yr)(25 **call** contracts)] =** $431,250** for a
strike rate = **4.75%** APR** **= 9,525-strike**
**[(9.40%)($1,000,000)(3/12 yr)(25

The effective floor rates are computed below:

9,425 **call** strike price floor rate = 5.75% +0.45% - 3.30%
premium = **2.90%** APR effective rate

9,450 **call** strike price floor rate = 5.50% +0.45% - 1.45% premium =** 4.50%**
APR effective rate

9,475 **call** strike price floor rate = 5.25% +0.45% - 0.40% premium = **5.30%**
APR effective rate

9,500 **call** strike price floor rate = 5.00% +0.45% - 0.10% premium = **5.35%**
APR effective rate

Part C:

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
1.45% APR call option premium for a September settlement translates to a dollar amount of
(1.45%)($1,000,000) = $14,500 per year. However, the time period between June 17 and
September 17 is only three months, reducing the premium cost to ($14,500)(3/12 yr) =
$3,625 per call option contract. Hence, 25 contracts cost FloorIT Bank ($3,625)(25) =
$90,625.

This is explained 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 call option having a listed premium of 1.45 will have a cost of $3,625 = (1.45%)($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=1.45, the dollar cost of the Eurodollar interest rate option is $3,625 = ($2,500)(1.45). 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 call option having a premiums
of J, A, and S respectively in **Exhibit
1**? For example, for a 9,450-strike price July call option, we find J = 1.00 =
(1.000%)(100) in **Exhibit 1**.
For a 9,450-strike price August option, we find A = 1.25 = (1.25)(100). For a 9,500-strike
price September option, we find S = 0.10 = (0.10%)(100) in Exhibit 1. What are the
corresponding scaling factors used to compute the call 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=1.00 in Exhibit 1, the cost of the one-month option is $2,500=($2,500)(1.00). When A=1.25, the cost of the two-month option is $3,125=($2,500)(1.25). When S=0.10, the cost of the three-month option is $250=($2,500)(0.10).

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 **

Part A:

Suppose that on June 17, FloorIT Bank elects to floor the $25 million forecasted variable
rate lending planned for September 17. Assume Pete Boniff decides to place a floor on the
variable rate by purchasing 25 September call options having a strike price of 9,450 in
**Exhibit 1**. If LIBOR falls
to a 4.00% APR on September 17, compute the September 17 cash settlement (positive or
negative) for FloorIT interest rate hedge of a lending 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
call 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 at LIBOR=4.20% becomes (5.50%-4.00%)($25m)(3/12
yr) = $93,750

__Less the June 17 cost (premium) for 25 hedging option contracts =
-(1.45)($2,500)(25) = - 90,625__

__Net income on the 25 hedging option contracts having a 9,450-strike price
= $ 3,125__

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

September 17 settlement at LIBOR=4.20% becomes (5.50%-4.00%)($25m)(3/12
yr) = $93,750

__Less the June 17 cost (premium) for 25 contracts =
-(1.45%)($10,000)(25) (3/12 yr) = - 90,625__

__Net income on the 25 hedging option contracts having a 9,450-strike price
= $ 3,125__

Net interest on $25 million from September 17 to December 17 at 4.00% spot rate+0.45% =
**$278,125**

Net revenue of hedged loan =** $278,125** revenue + **$3,125**
hedge = **$281,250** for three months

Proof calculation = ($25,000,000)(4.50% floor rate)(0.25 yr)
= **$281,250** for
three months

Part B:

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

[($281,250/$25,000,000)(12/3 quarters) = **4.50%**
which is equal to the hedged floor rate of 4.50%.

**Question 4**

Part A:

What portions of the call option’s 1.45% 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%. FloorIT Bank
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.

[(5.50% strike – 5.18 LIBOR)]
= **+0.32%** intrinsic value
portion of 1.45% June 17 premium

[1.45% total - (+0.32% intrinsic)] = **+1.13%**
positive time value portion of 1.45% June 17 premium

Part B:

What portions of the total cost (in dollars) of 25 call 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

[(+1.13 time value rate)($2500)(25 contracts)]
= **+$70,625** time value on
June 17

[(1.45 total) ($2500)(25 contracts)] = +**$20,000** intrinsic value + **$70,625**
time value = **$90,625**

**Question 5 **

What is the balance sheet asset or liability for the "Option Contracts"
account's current value reported on **August 31** for the 25 contracts purchased by
FloorIT Corporation on June 17? Assume the 25 options qualify as a cash flow interest rate
flooring 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 call option contract is given near the bottom of
**Exhibit 1** as 0.90 for August 31.
The spot LIBOR rate is 4.70%.

The balance sheet value is to be marked to-market at **$56,250**
= ($2,500)(0.90)(25 contracts).

This represents a decrease of $34,375 from $90,625 to $56,250 due
to a spot premium decrease from 1.45% to 0.90% 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 flooring hedge of the forecasted loan transaction's interest rate.

Hint: Intrinsic value is discussed in Bob Jensen’s 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.

[(5.50% strike – 5.18% LIBOR)] = **+0.32%**
intrinsic value portion of 1.45% June 17 premium

[1.45% total - (+0.32% intrinsic)] = **+1.13% **positive time value portion
of 1.45% June 17 premium

[(0.32 intrinsic value rate)($2500)(25 contracts)]
= **+$20,000** intrinsic value on June 17

[(+1.13 time value rate)($2500)(25 contracts)] = **+$70,625**
time value on June 17

[(1.45 total) ($2500)(25 contracts)] = **-$20,000** intrinsic value + **$70,625**
time value = **$90,625**

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 $90,625 and Cash is credited for $90,625. In subsequent calculations it will be assumed that time value is $53,121 for a plug into the equations below.

---------------------------------------------------------------------------------------------------------------------------------

[(5.50% strike – 4.70% LIBOR)] = **+0.80%** intrinsic value portion of
0.90% August 31 premium

[0.90% total - (+0.80% intrinsic)] = **+0.10%** positive time value portion
of 0.90% Aug. 31 premium

[(+0.80% intrinsic value rate)($2500)(25 contracts)]
= **+$50,000** intrinsic value on August 31

[(+0.10% time value rate)($2500)(25 contracts)]
= +**$ 6,250** time
value on August 31

[(0.90% total) ($2500)(25 contracts)] = **+$50,000** intrinsic value + **$6,250**
time value = **$56,250**

Change in intrinsic value = +$50,000 - ($0) = **+$50.000**
between June 17 and Aug. 31

__Change in time value = +$6,250 – $90,625 = -$84,375 between
June 17 and Aug. 31__

Change in intrinsic value = +$50,000 - ($0)
= **+$50,000** between June 17 and Aug. 31

__Change in earnings = -$34,375 - (+$50,000) = -$15,625 between
June 17 and Aug. 31__

---------------------------------------------------------------------------------------------------------------------------------

All of the $50,000 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 **$15,625**
degradation of time value that is debited to current earnings (through Interest Expense).

[ **$50,000** credit bal. in OCI + **$6,250**
time value = **$56,250**. option value on August 31].

**Question 7 **

Discuss the outcome of all transactions through December after Pete Boniff’s decision
to floor the hedge at a 9,450-strike price. For example, what is the net cost of the
hedged interest on $25 million if LIBOR drops to 4% on September 17? What is the net cost
if LIBOR drops to 3%?

Pete Boniff decided to pay $90,625 on June 17 for the piece of
mind of converting a variable loan rate of LIBOR+0.45% to a minimum fixed (floored) rate
of 4.50%. If LIBOR drops to 4.00%, the net interest revenue will be
($25,000,000)(4.50%)(3/12 yr) = $281,250. **. The hedged revenue is fixed at $281,250 for
any value of LIBOR below the 5.50% strike rate, 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 $281,250 for a 2.00% LIBOR, a 3.00% LIBOR, and a
4.50% LIBOR on September 17

**Question 8 **

Part A:

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

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 floor rate from the Question 1 answer is 4.50% after factoring in the cost (premium) of the call 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 revenue from the loan

[ +($25,000,000)(5.50% - 5.49%)(3/12 yr) = **+$
625** settlement of the 25 call options

[ -($2,500)(1.45 cost of the options) ]
= **-$
90,625** aggregate premiums on June 17

Net revenue from all transactions = **+$373,750 + $625 -
$90,625
=
$281,250**

Recall that the floored hedge revenue = ($25,000,000)(4.50%)(3/12 yr)
=** $281,250**

When the call option is only slightly in-the-money, FloorIT Bank exactly attains its floor rate of interest under the call hedge.

Part B:

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

[($281,250/$25,000,000)(12/3 quarters) = **4.50%**
which is exactly equal to the hedged floor rate of 4.50%.

**Question 9**

Part A:

What is the net revenue of the hedged interest on $25 million if LIBOR is 5.51% on
September 17?

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 floor rate from the Question 1 answer is 4.50% after factoring in the cost (premium) of the call 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 revenue from the loan

[ +($25,000,000)(0 since LIBOR>5.50%) =**
+$ 0** settlement of the 25
call options

[ -($2,500)(1.45 cost of the options) ]
= **-$
90,625** aggregate premiums on June 17

Net revenue from all transactions
= **+$372,500 + $0 - $90,625
= $281,875**

Recall that the floored hedge revenue = ($25,000,000)(4.50%)(3/12 yr) = **$281,250**

When the call option is only slightly out-of-the-money, FloorIT Bank can obtain slightly more than the floor earnings on the $25,000,000 loan.

Part B:

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

[($281,875/$25,000,000)(12/3 quarters) =** 4.51%**
which is** slightly greater** than the hedged floor rate of 4.50%.

**Question 10 **

Part A:

What is the net revenue of the hedged interest on $25 million if LIBOR is 6.50% on
September 17?

Hint: Recall that the strike rate is 5.50% corresponding to the strike rate of 9,450 basis points. The floor rate from the Question 1 answer is 4.50% after factoring in the cost (premium) of the call option at the 9,450-strike price having a strike rate of 5.50%.

[ +($25,000,000)(6.50% + 0.45%)(3/12 yr)
= **+$434,375** interest revenue from the loan

[ +($25,000,000)(0 since LIBOR>5.50%) = +**$
0** settlement
of the 25 call options

[ -($2,500)(1.45 cost of the options) ]
= **-$
90,625** aggregate premiums on June 17

Net revenue from all transactions = **+$434,375+ $0 -
$90,625
=
$343,750**

Recall that the floored hedge revenue = ($25,000,000)(4.50%)(3/12 yr) = **$281,250**

When the call option is high out-of-the-money, FloorIT Bank can obtain significantly more than the floor earnings on the $25,000,000 loan.

Part B:

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

[($343,750/$25,000,000)(12/3 quarters) = **5.50**%
which is **much greater** than the hedged floor rate of 4.50%.

**Question 11 **

Part A:

What is the net revenue of the hedged interest on $25 million if LIBOR plunges to 3.00% on
September 17? Given that it hedged its revenue at a floor amount of $281,250, what does
LIBOR have to be for the FloorIT Bank to earn more than this floor rate?

Hint: Recall that the strike rate is 5.50% corresponding to the strike rate of 9,450 basis points. The floor rate from the Question 1 answer is 4.50% after factoring in the cost (premium) of the call option at the 9,450-strike price having a strike rate of 5.50%.

[ +($25,000,000)(3.00% + 0.45%)(3/12 yr) = **+$215,625**
interest revenue from the loan

[ +($25,000,000)(5.50% - 3.00%)(3.12 yr) = **+$156,250
**settlement of the 25 call options

[ -($2,500)(1.45 cost of the options) ]
= **-$
90,625** aggregate premiums on June 17

Net revenue from all transactions = **+$215,625 + $156,250
- $90,625 = $281,250**

Recall that the effective floor revenue = ($25,000,000)(4.50%)(3/12 yr) = **$281,250**

Since FloorIT Bank hedged at a 4.50% effective floor rate, it really does not matter how low LIBOR plunges below that point. However, when the flooring options go out-of-the-money (i.e., when LIBOR exceeds 5.50%), the bank can earn more than the floor rate. It only earns the floored revenue of $281,250 if LIBOR does not rise above the strike rate of 5.50%.

Part B:

What is the net lending rate APR after the settlement of the 25 call hedging contracts
are factored into the calculation based upon a September 17 LIBOR of 3.00%?

[($281,250/$25,000,000)(12/3 quarters) = **4.50%**
which is **exactly equal t**o the hedged floor rate of 4.50%.

**Question 12 **

Compute value of the adjustment (A) in the equation below that derives the FloorIT
Corporation lending rate whenever the call options are in the money:

R = LIBOR

-A %for LIBOR >5.50%

R = 4.50% for LIBOR <5.50%R = LIBOR -

1.00%for LIBOR >5.50%

R = 4.50% for LIBOR <5.50%

**Question 13 **

Draw a graph showing the loan rate net of the hedging impact. In other words, graph the
floored rate up to the kink point and then show the rising loan rate after the kink point.
The graph’s abscissa should show possible values of the September 17 LIBOR ranging
from 2.00% to 10.0%. The graph’s ordinate should show the net loan rate.

Hint: The net loan rate will be linear (i.e., LIBOR+0.45%) after the kink point. Prior
to that kink point it remains flat at the floored interest rate resulting from the
purchase of 25 call 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 14 **

Part A:

FloorIT Bank may have chosen any of the available strike prices shown for call options in
**Exhibit 1**. Draw a graph
showing the loan rates net of the hedging impact for September options having strike
prices of 9,425 versus 9,450 versus 9,475 basis points. In other words, graph the loan
rates up to the kink points and then show only the floored rates after the kink points.
The graph’s abscissa should show possible values of the September 17 LIBOR ranging
from 2.00% to 9.00%. The graph’s ordinate should show the net loan rates of the three
strike price choices.

**See Exhibit 3**.

Part B:

Based upon the outcomes in the graph, does it appear that Pete Boniff made an
optimal hedge for FloorIT Bank?

Hint: Look at your answers to Question 1.

For a lower cost of $25,000, he could have obtained a 5.30%
effective floor rate using the 9,475 strike price corresponding a strike interest rate of
5.25% APR. For a mere $6,250, he could have a floor rate of 5.35% having a strike price of
9,500. His 9,450-strike price call option (costing $90,625) ended up with an effective
floor rate of 4.50. Pete Boniff made a bad choice. He would have been much better off
paying only $6,250 for the highest effective floor rate of 5.35%. Not only is the floor
rate higher, he would have saved $90,625 - $6,250 = $84,375.

**Question 15 **

The **Exhibit 1** premium for
the September call option using the 9,500-strike price is 0.10% that translates into a
$25,000 cost of 25 hedging contracts on June 17. Its effective floor rate is 5.35%. The
premium for the September call option using the 9,450-strike price is 1.45% that
translates into a $90,625 cost of 25 hedging contracts on June 17. Its effective floor
rate is only 4.50%. What would the market premium in Exhibit 1 have to have been for the
9,450-strike price to become an effective floor rate of 5.35%? In that circumstance, how
much would the hedge cost have to be in lieu of the $90,625 cost actually paid by FloorIT
Bank on June 17?

9,450 **call** strike price floor rate = 5.50% +0.45% - **0.60%**
premium = 6.45% APR

9,500 **call** strike price floor rate = 5.00% +0.45% - 0.10% premium = 5.35% APR

The market set the premium at 1.45% APR.** This would have
to fall to 0.60%** if the 9,450-strike price would become as good for hedging
purposes as the 9,500-strike price. If the market price fell to 0.60%, the hedging cost
would fall from $90,625 to $37,500 as computed below:

[(1.45)($2500)(25 **call** contracts)] = $90,625 for a strike
rate of (10,000 – 9,450)/100 = 5.50% APR

[(**0.60**)($2500)(25 **call** contracts)] = $37,500 for a strike rate of
(10,000 – 9,450)/100 = 5.50% APR

**Question 16 **

If the September call option premium had been **0.50** instead of 1.45 for
the 9,450-strike price in **Exhibit 1**,
what would the optimal choice have been for Pete Boniff to floor 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 4.50% 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 call option is compared with the 9,500 strike-price premium as follows:

[(**0.50**)($2500)(25 **call** contracts)] =
$31,250 for a strike rate of (10,000 – 9,450)/100 = 5.50% APR

[(0.10)($2500)(25 **call** contracts)] = $ 6,250 for a strike rate of (10,000 –
9,500)/100 = 5.00% APR

The effective floor rates are as follows for all **Exhibit 1** alternatives are as follows:

9,450 **call** strike price floor rate = 5.50% +0.45% -**
0.50%** premium = 5.45% APR

9,500 **call** strike price floor rate = 5.00% +0.45% - 0.10% premium = 5.35% APR

In this revised example, FloorIT Bank can get a 5.35% effective
lending floor at the lowest June 17 cost of $6,250. However, **it can get a higher
effective floor rate of 5.45% if it is willing to pay $31,25**0. The choices are
thus to either have the highest 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
$31,250 for a 0.50% premium having an effective floor of 5.45%. However, in **Exhibit 1**the
9,450-strike price was actually $90,625 from a 1.45% premium and an effective floor of
4.50%, Pete Boniff made a poor *ex ante* choice on June 17. The 9,500-price is always
better given the CME market
premiums in Exhibit 1.

**Question 17 **

Hedging a lending rate via a call option is only one of several alternatives for hedging a
lending rate. Other alternatives include interest rate swaps and interest rate forwards
and futures. What is the main advantage of options in hedging strategies?

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 FloorIT purchased 25 call contracts for
$90,625 on June 17, the maximum harm done no matter what happens is a loss of $90,625 on
the call 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. 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, FloorIT has no interest payments to swap.

**Question 18 **

Part A:

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 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:

[(1.45% spot premium on June 17)($2500)(25 contracts) = **$90,625**
asset value

[(1.58% spot premium on June 30)($2500)(25 contracts) = **$98,750**
asset value

[(1.10% spot premium on July 31)($2500)(25 contracts) =** $68,750 **asset
value

[(0.01% spot premium on Aug. 31)($2500)(25 contracts) = **$ 6,250**
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:

[(5.50% strike – 5.18 LIBOR)] = **+0.32%**
intrinsic value portion of 1.45% June 17 premium

[1.45% total - (+0.32% intrinsic)] = **+1.13%** positive time value
portion of 1.45% June 17 premium

[(+0.32 intrinsic value rate)($2500)(25 contracts)]
= **+$20,000** intrinsic value on June 17

[(+1.13 time value rate)($2500)(25 contracts)]
= **+$70,625** time
value on June 17

[(1.45 total) ($2500)(25 contracts)] = **+$20,000** intrinsic value +**
$70,625** time value =** $90,625**

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 $90,625 and Cash is credited for $90,625. In subsequent calculations it will be assumed that time value is $90,625 for a plug into the equations below.

--------------------------------------------------------------------------------------------------------------------------------

[(5.50% strike) – 5.10%]
= +0.40% intrinsic value portion of 1.58% June 30 premium

[1.58% total - (+0.4000% intrinsic)] = +1.18% positive time value portion of 1.58% June 30
premium

[( +0.40 intrinsic value rate)($2500)(25 contracts)]
= +$25,000 intrinsic value on June 30

[(+1.18 time value rate)($2500)(25 contracts)]
= +$73,750 time value on June
30

[(1.58 total) ($2500)(25 contracts)] = +$25,000 intrinsic value + $73,750 time value =
$98,750

Change in intrinsic value = +$25,000 - ( +$20,000)
= +$ 5.000 between June 17 and June 30

__Change in time value = +$73,750 - (+$70,625)
= +$ 3,125 between June 17
and June 30__

__Change in total value = $34,375 - $90,625
= +$ 8,125 between June 17 and June 30__

**Change in OCI** = +$25,000 - (-$0)
= **+$25,000** between June 17 and **June 30**

**Change in earnings** = +$8,125 - (+$25,000) = **-$16,875**
between June 17 and **June 30**

**Change in total value** = $34,375 - $90,625 = **+$
8,125** between June 17 and **June 30**

--------------------------------------------------------------------------------------------------------------------------------

[(5.50% strike – 5.38 LIBOR)] =
+0.12% intrinsic value portion of 1.10% July 31 premium

[1.10% total - (+0.12% intrinsic)] = +0.98% positive time value portion of 1.10%
July 31 premium

[(+0.12 intrinsic value rate)($2500)(25 contracts)]
= +$ 7,500 intrinsic value on July 31

[(+0.98 time value rate)($2500)(25 contracts)]
= +$61.250 time value on July 31

[(1.10 total) ($2500)(25 contracts)] = +$ 7,500 intrinsic value + $61,250 time value
= $68,750

Change in intrinsic value = +$ 7,500 - (+$25,000)
= -$17,500 between June 30 and July 31

__Change in time value = +$61,250 - (+73,750)
= -$12.500 between June 30
and July 3__1

__Change in total value = $68,750 - $98,750
= -$30,000 between June 30 and July 31__

**Change in OCI** = +$ 7,500 - (+$25,000)
= **-$17,500
**between June 30 and **July 31**

**Change in earnings** = +$30,000 - (-$17,500)
= **-$12,500** between June 30 and
**July 31**

**Change in total value** = $68,750 - $98,750
=** -$30,000**
between June 30 and **July 31**

--------------------------------------------------------------------------------------------------------------------------------

[(5.50% strike- 4.70% LIBOR)] =
+0.80% intrinsic value portion of 0.90% August 31 premium

[0.90% total - (+0.80% intrinsic)] = +0.10% positive time value portion
of 0.90% Aug. 31 premium

[(+0.80 intrinsic value rate)($2500)(25 contracts)]
= +$50,000 intrinsic value on August 31

[(+0.10 time value rate)($2500)(25 contracts)]
= +$ 6,250 time value on
August 31

[(0.10 total) ($2500)(25 contracts)] = +$50,000 intrinsic value + $6,250 time value =
$56,250

Change in intrinsic value = +$50,000 - (+$ 7,500)
= +$42,500 between July 31 and August 31

__Change in time value = +$ 6,250 - (+$61,250)
= -$55,000 between July 31 and
August 31__

__Change in total value = $56,250 - $68,750
= -$12,500 between July 31 and August 31__

**Change in OCI** = +$50,000 - ( +$ 7,500)
= **+$42,500**
between July 31 and **August 31**

**Change in earnings** = -$12,500 - (+$42,575)
= ** -$55,000** between July 31
and **August 31**

**Change in total value** = $56,250 - $68,750
= ** -$12,500**
between July 31 and **August 31**

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

September 17 settlement at LIBOR=4.20% becomes
(5.50%-4.00%)($25m)(3/12 yr) = $93,750

__Less the June 17 cost (premium) for 25 hedging option contracts = -(1.45)($2,500)(25)
= - 90,625
Net income on the 25 hedging option contracts having a 9,450-strike price
= $ 3,125__

**Note that under P****aragraph 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 $3,125 will remain in OCI until some portion of the interest on
the $25,000,000 receivable is credited to earnings. For example, if 10% of
the total note interest is credited to earnings, then 10% of the $3,125 would be
taken from OCI and be posted to earnings. In this illustration, however,
100% of the note interest will be credited 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 - ( +$50,000)
= -$50,000 between Aug. 31 and Sept. 17

__Change in time value = +$0 - ( +$ 6,250)
= -$ 6,250 between Aug.
31 and Sept. 17__

__Change in total value = +$0 - (+$56,250)
= -$56,250 between Aug. 31
and Sept. 17__

**Change in OC**I = $3,125 - ( -$50,000)
= **+$46,975 **Aug. 31-**Sept. 17**

__
Change in earnings = -$84,375
= -$84,375 Aug. 31-Sept. 17__

September 17 settlement at LIBOR=4.20% becomes
(5.50%-4.00%)($25m)(3/12 yr) = $93,750

__Less the June 17 cost (premium) for 25 hedging option contracts = -(1.45)($2,500)(25)
= - 90,625
Net income on the 25 hedging option contracts having a 9,450-strike price
= $ 3,125__

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

September 17 settlement at LIBOR=4.20% becomes
(5.50%-4.00%)($25m)(3/12 yr) = $93,750

__Less the June 17 cost (premium) for 25 contracts = -(1.45%)($10,000)(25) (3/12 yr)
= - 90,625
Net income on the 25 hedging option contracts having a 9,450-strike price
= $ 3,125 __

Net interest on $25 million from September 17 to December 17 at 4.00% spot rate+0.45% = $278,125

Net revenue of hedged loan = $278,125 revenue + $3,125 hedge
= **$281,250 **for three months

Proof calculation = ($25,000,000)(4.50% floor rate)(0.25 yr)
= **$281,250**
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 P****aragraph 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 $3,125 will remain in OCI until some portion of the interest on
the $25,000,000 receivable is credited to earnings. For example, if 10% of
the total note interest is credited to earnings, then 10% of the $3,125 would be
taken from OCI and be posted to earnings. In this illustration, however,
100% of the note interest will be credited 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:

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

[($281,250/$25,000,000)(12/3 quarters) = **4.50%**
which is equal to the hedged floor rate of 4.50%.

**Question 19 **

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 20 **

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 FloorIT 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 an entity'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 FloorIT Bank signed an iron-clad contract to lend $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 FloorIT instead had a firm commitment to lend 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 call options
purchased by FloorIT Bank could be maintained on the books at historical cost ($90,625)
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 21 **

FloorIT Bank has a policy of never investing in options as speculations. Call options such
as those illustrated in this case are always "held to maturity" up to the time
the hedged loan transpires. Pete Boniff argued that the 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 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 call options on a forecasted loan transaction, there are all sorts of
uncertainties. First and foremost, there is the uncertainty that the forecasted loan will
never transpire. If that happens, FloorIT Bank ends up with having to take whatever
speculative gain or loss it gets when the option contracts are settled. There is no
assurance that high interest revenue from a variable rate loan will cover the cost of the
options 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 options contracts used to
hedge forecasted transactions.

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

For hedging via put options, see the CapIT Corporation Case.

For heding via Eurodollar futures contracts, see following cases: