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4-1 CASE 5 Cash Flow Hedge of Variable-Rate Debt On 1/1/X1, XYZ, a ‘B’ rated entity, issued a $100 million note at LIBOR, semiannual payments and semiannual variable-rate reset dates, noncallable, 5- year term Current LIBOR is 5.7% XYZ wants to lock in a 6% fixed rate; XYZ enters into an interest-rate swap to pay 6% fixed and receive LIBOR Swap terms include a $100 million notional principal, a 5-year term, and semiannual variable-rate reset At hedge inception, the fair value of the swap is zero

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4-2 CASE 5 Cash Flow Hedge of Variable-Rate Debt Assume that during the six-month period ended 6/30/X1, interest rates increase. Also, a comparable term pay-fixed, receive-variable interest rate swap is priced at 6/30/X1 at a 7% pay-fixed rate. Given these facts, the direction of fair value changes are as follows: – Variable-rate debt—no change in value given that rates reset to market – Pay-fixed 6%, receive-variable interest rate swap—increases in value

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4-3 6/30/X112/31/X1 Variable-rate debt100,000,000100,000,000 Variable rate 5.7%6.7%* Semiannual debt payment2,850,0003,350,000 Swap receive variable (2,850,000)(3,350,000) Swap fixed payment3,000,0003,000,000 Net debt and swap interest expense3,000,0003,000,000 *Rate increased 100 basis points on 7/1/X1 reset. CASE 5 Cash Flow Hedge of Variable-Rate Debt

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4-4 6/30/X1 12/31/X1 Fair value of pay 6% swap 3,804,000 1 3,437,000 2 1 PV of nine $500,000 semiannual payments, discounted at 3.5% per period 2 PV of eight $500,000 semiannual payments, discounted at 3.5% per period CASE 5 Cash Flow Hedge of Variable-Rate Debt

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4-5 At 6/30/X1 Interest expense 2,850,000 Interest payable2,850,000 To record debt interest accrual Interest receivable 2,850,000 Interest expense 150,000 Interest payable3,000,000 To record swap accrual (receive 5.7% and pay-fixed 6%) Swap asset 3,804,000 OCI3,804,000 To record fair value of swap excluding accrual CASE 5 Cash Flow Hedge of Variable-Rate Debt

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4-6 At 12/31/X1, rates have remained the same as at 6/30/X1 and the swap market value has decreased to $3,437,000 due the 12/31/X1 payment and time passage. Interest rates reset on 6/30/X1 for both the swap and variable-rate debt reflecting a 100 basis point increase in LIBOR. CASE 5 Cash Flow Hedge of Variable-Rate Debt

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4-7 At 12/31/X1 Interest expense 3,350,000 Interest payable3,350,000 To record debt interest accrual ((.067 × $100m)/2) Interest receivable 3,350,000 Interest payable 3,000,000 Interest expense 350,000 To record swap accrual (receive 6.7% and pay 6%) OCI 367,000 Swap asset 367,000 To record fair value change of swap excluding accrual CASE 5 Cash Flow Hedge of Variable-Rate Debt

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4-8 CASE 5 Cash Flow Hedge of Variable-Rate Debt XYZ documented that the swap and variable- rate debt terms for the nominal amounts, payment frequency, reset dates, and maturity match The effectiveness of the hedge was demonstrated throughout the term of the hedge This hedge is not exposed to basis risk because the swap and debt each have the identical variable rate (LIBOR)

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4-9 CASE 6 Fair Value Hedge of Fixed Rate Debt Long-Haul Method On 4/3/00, GlobalTechCoSub issues at par a non-callable, 5-year, $100 million note at 8% fixed interest, semiannual payments (debt is rated A1) On 4/3/00, GlobalTechCo also enters into a 5-year interest rate swap; $101,970,000 notional amount, pay LIBOR plus 78.5 basis points, receive fixed at 8%, semiannual settlement and interest reset dates Net interest outflow: LIBOR plus 78.5 bps (current LIBOR at 6.29%) Swap is at-market, therefore, no premium required

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4-10 CASE 6 Fair Value Hedge of Fixed Rate Debt Long-Haul Method Hedged item: $100 million, 5-year, 8 percent fixed rate, non-callable debt Hedge Strategy: Eliminate debt fair value changes attributable to changes in the LIBOR swap rate by converting interest payments to LIBOR based variable-rate. Hedging instrument: Interest rate swap, terms: pay LIBOR plus 78.5 basis points, receive 8% fixed rate. Semiannual swap settlement and rate reset at $/3 and 10/5. Swap fair value at hedge inception = 0.

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4-11 CASE 6 Fair Value Hedge of Fixed Rate Debt Long-Haul Method Statement of hedge effectiveness: A duration-weighted hedge ratio calculates the swap notional amount necessary to offset the debt’s fair value changes attributable to changes in the LIBOR swap rate. PV01 debt = 4.14 PV01 swap = 4.06 Hedge ratio = PV01 debt/PV01 swap = 4.14/4.06 = 1.0197 Swap notional = 1.0197 x $100 million = $101,970,000

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4-12 CASE 6 Fair Value Hedge of Fixed Rate Debt Long-Haul Method Statement of hedge effectiveness (continued): Therefore, a 1 basis point shift in the GlobalTechCoSub $100 million debt issuance equals a 1 basis point shift in $101,970,000 notional of the LIBOR based swap.

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4-13 CASE 6 Fair Value Hedge of Fixed Rate Debt Long-Haul Method Statement of hedge effectiveness (continued): The swap accrual for its semi-annual settlement is excluded from the swap’s calculation of its change in fair value. The debts interest accrual is also excluded from its calculation of changes in fair value. This simplifies the hedge effectiveness calculation On a prospective and retrospective basis, hedge effectiveness will be assessed based upon a regression analysis of changes in the LIBOR swap rate and changes in the bond’s present value, calculated based on its yield at hedge inception, adjusted for changes in the LIBOR swap rate (DIG Issue E7)

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4-14 CASE 6 Effect of 100 Basis Point Rate Increase at 6/30/00 6/30/00 swap fair value change, Receive 8% fixed, pay LIBOR+ 78.5 basis points swap$4,252,000 Less: Swap accrual for the period 4/3-6/30 236,000 Net Swap Loss$4,016,000 (Interest rate shift assumed to be a parallel shift in the yield curve)

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4-15 CASE 6 Recording Hedge Activity 4/30/00 No entry required because swap entered into at-the-money 6/30/00 Dr Debt3,775,620 Cr Earnings 3,775,620 Dr Earnings4,016,000 Cr Swap Liability 4,016,000 To record swap and debt fair value changes attributable to changes in the LIBOR swap rate, excluding accruals

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4-16 CASE 6 Ineffectiveness Recorded at 6/30/00 The net earnings impact of the hedge was $240,380 due to some imprecision in the calculated hedge ratio. The hedge would continue to qualify for hedge accounting provided the regression analysis justified the result In practice, this result will be common The debt’s subsequent period changes in value attributable to changes in the LIBOR swap rate are computed by comparing its prior period present value (not the same as its fair value) to its current period present value, excluding accrued interest

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