Company ABC ABC purchased floating rate securities on 1/1/Y1 for $1,000.00 & classified them as "available for sale."
- The interest rate on these securities is equal to LIBOR (as of January 1) plus 1%.
- On 1/1/Y1, LIBOR was 3%.
- The rate is reset once a year using LIBOR as of January 1.
- These bonds have four-year maturity.
- At end of year Y1, LIBOR decreased to 2.90%.
- The rate on the securities is reset on 1/1/ Y2.
• Also on 1/1/Y2, the management of ABC wanted to keep the investments but not the risk of interest rate. On that day, ABC entered into a contract with a Bank/Dealer to hedge interest rate risk.
- Under this hedging contract, ABC would receive fixed rate from the Bank/Dear and pay floating.
- As of 1/1/Y2, the zero-coupon curve showed:
Rate for one year bond 2.75%
Rate for two year bond 2.75%
Rate for three year bond 3.20%
Rate for four year bond 3.50%.
Required: for simplification of this case, assume that the hedge is highly effective.
(1) Find out the fixed rate of interest of this swap contract.
(2) Explain how the above transactions would be reported on the
books of ABC.
Continue the cash flow hedge accounting illustration
On January 1, Y3,
- LIBOR increased to 3.1%.
- The zero-coupon curve also changed.
- Rate for a one year bond 2.85%
- Rate for a two year bond 3.40%
- Rate for a three year bond 3.50%.
Required : for simplification of this case, assume that the hedge is highly effective.
• Show the effect of these changes on the books of Company ABC