Assume an interest rate swap with a notional value of $1,000,000. Firm A receives fixed and pays variable. The fixed rate on December 31, 2000, is eight percent. The swap has two years to run with variable interest rates of 7.8 percent and 7.6 percent expected on December 31, 2001, and 2002, respectively (annual settlements are assumed for simplicity). Firm A's discount rate is eight percent.
Required:
a. Determine the fair value of the derivative and state whether it would be an asset or a liability.
b. Assume that the swap occurred prior to December 31, 2000, and the interest rate swap contract had a debit balance of $1,000. Under this circumstance make the entry for the fair value as of December 31, 2000.