Intermediate Accounting, 10 Ed
10th Edition
ISBN: 9781260310177
Author: Mark W. Nelson, Wayne B. Thomas J. David Spiceland
Publisher: McGraw-Hill Education
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Chapter A, Problem A.3Q
To determine
Derivatives: Derivatives are some financial instruments which are meant for managing risk and safeguard the risk created by other financial instruments. These financial instruments derive the values from the future value of underlying security or index. Some examples of derivatives are forward contracts, interest rate swaps, futures, and options.
Interest rate swap: This is a type of derivative used by two parties under a contract to exchange the consequences (net cash difference between interest payments) of fixed interest rate for floating interest rate, or vice versa, without exchanging the principal or notional amounts.
To determine: The effect of gain or loss on the notional difference of $500,000, the difference between fixed rate debt of $2,000,000, and the $2,500,000 interest rate swap
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Firm ABC enters a 5-year swap with firm XYZ to pay LIBOR in return for a fixed 6% rate on notional principal of $10 million. Two years from now, the market rate on 3-year swaps is LIBOR for 5%; at this time, firm XYZ goes bankrupt and defaults on its swap obligation.a. Why is firm ABC harmed by the default?b. What is the market value of the loss incurred by ABC as a result of the default?c. Suppose instead that ABC had gone bankrupt. How do you think the swap would be treated in the reorganization of the firm?
Suppose that Phoenix bank seeks to reduce its interest rate risk in regards to its holdings of fixed-rate (10%) mortgages via the use of interest rate
swaps. To this end, Phoenix and Epitome bank come to an agreement of a swap arrangement, whereby Epitome receives fixed-rate payments from
Phoenix's mortgages, equaling 8%. In exchange, Phoenix receives variable payments from Epitome, equaling the LIBOR rate (the interbank lending
rate for Eurobanks).
Assume that Phoenix's cost of funds (or the rate owed on its deposits) is equal to the LIBOR rate, less 1%.
The following table details the swap arrangement from the point of view of Phoenix bank for various possible values of LIBOR.
Possible Future LIBOR Rates
Unhedged Strategy
7%
8%
9%
10% 11%
12%
Average rate on existing mortgages
10%
10%
10%
10%
10%
10%
Average cost of deposits
5
6
7
8
9
10
Spread
5
4
3
2
1
0
Hedging with Interest Rate Swap
Fixed interest earned on fixed-rate mortgages
10%
10%
10%
10%
10%
10%
Fixed interest owed on swap…
D3)
The value of a derivative that pays off $100 after one year if a company has defaulted during the year is $5. The value of a derivative that pays off $100 after one year if a company has not defaulted is $97.
(a) What is the risk-free rate?
(b) What is the risk-neutral probability of default?
Chapter A Solutions
Intermediate Accounting, 10 Ed
Ch. A - Prob. A.2QCh. A - Prob. A.3QCh. A - Prob. A.4QCh. A - What is the effect on interest of an interest rate...Ch. A - How are derivatives reported on the balance sheet?...Ch. A - When is a gain or a loss from a cash flow hedge...Ch. A - Prob. A.1ECh. A - Research Case A4 Issue related to the derivatives...
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- (Motivation for Interest rate swap) National Bank has a $200b Adjustable Rate Mortgage (ARM) as a liability on its balance sheet. The interest rate on the ARM is 2.34%+Libor. As a result, the bank will have to pay floating interest. The bank is considering hedging the risk in the interest payment to the ARM with a three-year interest rate swap. What will be the Bank's net interest rate of payment if it chooses the right swap? Answer: ____________%. Euro-€ Swiss franc U. S. dollar Japanese yen Years Bid Ask Bid Ask Bid Ask Bid Ask 2 3.08 3.12 1.68 1.76 5.43 5.46 0.45 0.49 3 3.25 3.29 2.41 2.68 5.78 6.02 0.56 0.59arrow_forwardWhich of the following are typical negotiable certificate of deposit (NCD) denominations? Check all that apply. $300,000 $500,000 $1,000,000 $5,000,000 Which of the following are characteristics of negotiable certificates of deposit (NCD)? Check all that apply. Firms are the most common direct investors in these securities. They provide a return in the form of interest along with the difference between the secondary market selling price and the original purchase price. Activity in their secondary market is low. Their denominations are typically in multiples of $100,000. Suppose Larry purchased an NCD a year ago on the secondary market for $991,000 and redeems it today upon maturity for $1,000,000 plus $44,000 in interest. The annualized yield on this NCD is: 4.81% 5.19% 5.35% 5.78%arrow_forward1. If bonds are sold at a discount and the straight-line method of amortization is used, interest expense in earlier years will: (A) Exceed what is would have been had the effective interest rate method of amortization been used. (B) Be less than what it would have been had the effective interest rate method of amortization been used. (C) Be the same as it would have been had the effective interest rate method of amortization been used. (D) None of the above.arrow_forward
- 38. In a typical swap transaction, two parties agree to exchange cash flows at future points in time. Group of answer choices True False 39. A disadvantage of using traditional financial ratios is that they usually reflect accounting values rather than economic values. Group of answer choices True False 43. A debt rating of BB is considered investment grade if the issuing company is publicly traded but it is considered junk if issued by a private company. Group of answer choices True Falsearrow_forwardAccounting for Fair Value Hedge: Interest Rate Swap On January 1 of Year 1, Innovative Lab issued a 4-year $50,000 note to a local bank with fixed interest payments based on 6%, payable annually on December 31. To hedge the risk of a fixed interest payment, Innovative Lab entered into a 4-year interest rate swap agreement on January 1 of Year 1, calling for interest payments tied to a designated benchmark interest rate to a counterparty and receipt of interest based on 6%, negotiated at a notional amount of $50,000. The settlement date for the net cash payment is on December 31 of each year. The following table provides additional information related to the interest rate swap as forecasted over the next 4 years. Fair value: Interest rate swap Fair value: note payable Benchmark interest rate Required Dec. 31, Year 1 Dec. 31, Year 2 Dec. 31, Year 3 Dec. 31, Year 4 $200 $0 $50,200 4.2% $400 $50,400 4.0% $0 $50,000 5.2% $50,000 5.8% a. Record the required journal entries for Year 1, Year…arrow_forwardSuppose that some time ago a financial institution entered into a swap where it agreed to make semiannual payments at a rate of 3.5% per annum and receive LIBOR on a notional principal of $300 million. The swap now has a remaining life of 1.15 years. Payments will therefore be made 0.15, 0.65, and 1.15 years from today. The risk-free rates with continuous compounding for maturities of 0.15, 0.65, and 1.15 years are 2.8%, 3.2%, and 3.4%, respectively. We suppose that the forward LIBOR rates for the 0.15-to- 0.65 year and the 0.65-to-1.15 year periods are 3.4% and 3.7%, respectively, with semiannual compounding. The LIBOR rate applicable to the exchange in 0.15 years was determined 0.35 years ago. Suppose it is 2.9% with semiannual compounding. What is the floating cash flow at time 1.15 (in $ millions)?arrow_forward
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