Derivatives; interest rate swap; fixed rate debt; fair value change unrelated to

Question

Derivatives; interest rate swap; fixed rate debt; fair value change unrelated to hedged risk (This is a variation of Exercise A-2, modified to consider fair value change unrelated to hedged risk.) LLB Industries borrowed $200,000 from Trust Bank by issuing a two-year, 10% note, with interest payable quarterly. LLB entered into a two-year interest rate swap agreement on January 1, 2011 and designated the swap as a fair value hedge. Its intent was to hedge the risk that general interest rates will decline, causing the fair value of its debt to increase. The agreement called for the company to receive payment based on a 10% fixed interest rate on a notional amount of $200,000 and to pay interest based on a floating interest rate. Floating (LIBOR) settlement rates were 10% at January 1, 8% at March 31, and 6% at June 30, 2011. The fair values of the swap are quotes obtained from a derivatives dealer. Those quotes and the fair values of the note are as indicated below. The additional rise in the fair value of the note (higher than that of the swap) on June 30 was due to investors' perceptions that the creditworthiness of LLB was improving. Calculate the net cash settlement at June 30, 2011 Prepare the journal entries on June 30, 2011, to record the interest and necessary adjustments for changes in fair value.

Explanation / Answer

June 30
Fair value of interest rate swap = $11,394
Fair value of note payable = $220,000
Fixed rate payable quaterly= 10%/4 = 2.5%
Floating Rate = 6%/4 = 1.5%
Fixed interest receipts = $200,000 x 2.5% = $5,000
Less Floating payments = $200,000 x 1.5% = $3000
Net cash settlement= $2000

B.
Journal Entry

Date Particulars Debit Credit June 30 Interest Exp. $5,000 Cash $5,000 (To record Interest Exp.) June 30 Cash $2000 Interest Exp $2000 (To record net cash settlement) June 30 Interst rate Swap ($11,394 - $6,472) $4922 Holding gain-interest rate swap $4922 (To record change in fair value of the derivative) June 30 Holding loss- hedged note $135,28 Notes Payable $13528   (To record change in fair value of the note)

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