FAS 133 for Dummies: Accounting for Fair Value Hedges (Example 2)
July 22, 2009 | 4 Comments
“We are what we repeatedly do. Excellence, then, is not an act, but a habit.” Aristotle (382-322 B.C.)
Gulf of Guinea (GoG) LLC is planning to build a new theme park for $2,000,000,000.00. In order to finance this project, GoG issued $2,000,000,000.00 for 1.5 years on January 1, 2000 and agreed to pay LIBOR plus 10bp. This bond was bought in its entirety by BHIB. Worried that interest rate may rise in the future, thus reducing the fair value of the bond bought from GoG, BHIB entered into an interest rate swap agreement as follows:
- BHIB to pay LIBOR plus 10bp for 1.5 years.
- Receive fixed at 6.0% for 1.5 years
- The LIBOR rates with continuous compounding for 6-months and 12-months maturities (i) 5.55% and (ii) 5.8%
- There are no transaction costs
- Interest rate is paid semi-annually and continuously compounded
- The 6-month LIBOR rate at the last payment date was 5.25% (semi-annual compounding).
- BHIB fiscal year end is June 30th
The value of the interest rate swap on January 1, 2000 is zero. Value of a swap at inception is zero. This is because if the value is not zero, there is an opportunity for arbitrage and based on the efficient market hypothesis, arbitrageurs will quickly take advantage of that opportunity and reset the price back to zero almost instantaneously (real time). No entries are required except memorandum entries.
VALUATION:
Value of the swap as of June 30th, 2000 is calculated as follows:
Where Bfix = Present value of bond with underlying fixed-interest payment
and Bfl = Present value of bond with underlying variable-interest payment
Where
K = Fixed payment made on each payment date
L = Notional principal in swap agreement
ti = time until maturity (over the life of the swap)
ri = LIBOR zero rate corresponding to maturity ti
e = exponential
Calculation of Bfix:
Calculation of Bfl:
NB: Note that continuous compounding method is theoretical construct and not really used in practice. Discrete compounding is more common because it accounts for day count convention etc.
Since BHIB is the fixed-rate receiver and floating rate payer under this swap agreement, BHIB has a gain of $4.9780078703879. This will result in booking a swap asset for $4.9780078703879 in BHIB books. In addition, net interest gain/loss will result from the swap agreement as follows:
Fixed Rate interest receivable = $60,000,000.00
Variable Rate + 10 basis point = $53,500,000.00
Net Interest Income from swap = $6,500,000.00
Gulf of Guinea LLC will pay interest on the $2,000,000,000.00 loan @ LIBOR plus 10 basis point.
![= [0.0565 * (6/12)] * 2,000,000,000.00 = 56,500,000.00](http://blackherald.egoong.com/wp-content/plugins/wpmathpub/phpmathpublisher/img/math_980.5_95131af3c026ef3b0b87c7f3f88f2a1a.png "= [0.0565 * (6/12)] * 2,000,000,000.00 = 56,500,000.00")
ACCOUNTING ENTRIES:
FAS 133 states that:
For a derivative designated as hedging the exposure to changes in the fair value of a recognized asset or liability or a firm commitment (referred to as a fair value hedge), the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributable to the risk being hedged. The effect of that accounting is to reflect in earnings the extent to which the hedge is not effective in achieving offsetting changes in fair value.
Day 1 when loan was lent to GoG by BHIB:
Dr Bond $2,000,000,000.00
Cr Cash $2,000,000,000.00
(To record bond for $2,000,000,000 - January 1, 2000)
Day 1 when SWAP contract was entered.
(No entries required because this is just a memorandum entry).
Accounting Entries:
Dr Cash $6,500,000.00
Cr Income - Swap Interest Received $6,500,000.00
(To record NET SWAP Interest Received)
Dr Interest Income $56,500,000.00
Cr Income - Bond $56,500,000.00
(To record Interest Income Received on original bond acquired for $2,000,000,000.00 for 6 months)
Dr Swap Asset $4,978,007.87
Cr Unrealized holding gain/loss - income $4,978,007.87
(To record increase in FV of Swap Asset)
Change in FV of Loan = $2,000,000,000 - $1,997,298,773.51 = $2,701,226.49
Dr Unrealized holding gain/loss - income $2,701,226.49
Cr Bond $2,701,226.49
(To record decrease in FV of loan)
NET SWAP INTEREST INCOME:
Net Interest Income $6,500,000.00
LOAN INTEREST INCOME :
Accrued Interest Income $56,500,000.00
NET UNREALIZED HOLDING GAINS/LOSSES:
Increase in FV of swap asset $4,978,007.87
Decrease in Bond FV ($2,701,226.49)
Net Unrealized holding Gain $2,276,781.38
BALANCE SHEET PRESENTATION:
ASSETS:
Swap Assets: $4,978,007.87
Bond (Variable) $1,997,298,773.51
NET SWAP Interest Income Receivable $6,500,000.00
Interest Income - Cash $56,500,000.00
**Recalculate the FV of swap and bond every reporting period and repeat these entries.
Bibliography:
- Options, Futures and Other Derivatives “Fifth Edition” John C. Hull 2003
- Financial Accounting Standard 133 - AICPA
- Professional Risk Managers Handbook - Financial Instruments & Financial Markets (www.prmia.org)
NOTE: Thanks to our partners at Blackinsey & Company for providing the solution. Blackinsey & Company is a top tier strategy & management consulting outfit based in Washington, DC. This was created under creative commons and is copyleft. The interpretations and analysis presented in this article are purely for pedagogical exercise and Black Herald cannot be held responsible for any error of commission or omission. Thanks for visiting our website. You are always welcome . In the coming series, we will focus on cash flow and foreign currency hedges. We will also examine other types of derivatives namely forwards, futures, swaption, equity index and other exotic and examine different valuation tools including binomial theorem and Black-Scholes. Other third-party valuation tools will also be discussed.
If you like this article check out:
FAS 91 for Dummies and stay tuned for the following:
- FAS 133 for Dummies
- FAS 91 for Dummies (Sample with Prepayments)
- FIN 46 for Dummies
- FAS 115 for Dummies
- FAS 123(R) For Dummies
FAS 133 for Dummies: Accounting for Fair Value Hedges
July 13, 2009 | 1 Comment
“Imagination is more important than knowledge. For while knowledge defines all we currently know and understand, imagination points to all we might yet discover and create.” - Albert Einstein.
Black Herald International Bank (BHIB) bought a $200M 24 months 7% Fixed-Rate bond on January 1, 2000. The Chief Financial Officer of Black Herald, TFLASH, is concerned that interest rate may rise in the near future, thus decreasing the fair value of the bond purchased (inverse relationship between interest rate and bond price). Specifically, the Federal Government plans to increase interest rates in the future in order to pursue tighter monetary policies. In order to hedge this risk, TFLASH entered into an interest rate swap to pay fixed and receive variable benchmarked against the LIBOR as follows:
- Pay fixed @ 7% per annum compounded semi-annually on a swap with a notional of $200M.
- Assume that as at the reporting period ended March 31, 2000, the remaining payments dates are in 3, 9, 15, 21 months.
- The swap has a life of 24 months.
- The LIBOR rates with continuous compounding for 3-month, 9-month, 15-month and 21-month maturities are 9.1%, 10.2%, 11.3% and 12.4% respectively.
- The 6-month LIBOR rate at the last payment date was 8.0% (semi-annual compounding).
VALUATION:
The value of an interest rate swap is calculated as follows:
Where Bfix = Present value of bond with underlying fixed-interest payment
and Bfl = Present value of bond with underlying variable-interest payment
Where
K = Fixed payment made on each payment date
L = Notional principal in swap agreement
ti = time until maturity (over the life of the swap)
ri = LIBOR zero rate corresponding to maturity ti
e = exponential
*
* According to John C. Hull in the fifth edition of Options, Futures and Other Derivatives, the value of a floating rate bond is just the value before the next payment date discounted at ri for time ti because Bfl will equal L immediately after interest payment dates. Also note that swap payments are made in arrears.
Therefore, assuming June 30th, 2000 is an interest payment date, the value of the fixed rate paying bond will be (this is the present value of future cashflow stream of the bond from the date of calculation):
Hence, the value of the swap to party paying fixed and receiving variable:
ACCOUNTING ENTRIES:
FAS 133 states that:
For a derivative designated as hedging the exposure to changes in the fair value of a recognized asset or liability or a firm commitment (referred to as a fair value hedge), the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributable to the risk being hedged. The effect of that accounting is to reflect in earnings the extent to which the hedge is not effective in achieving offsetting changes in fair value.
Day 1 when bond was bought:
Dr Bonds $200,000,0000.00
Cr Cash $200,000,0000.00
(To record cash payment on acquisition of bond for $200,000,000)
Day 1 when SWAP contract was entered.
(No entries required because this is just a memorandum entry).
As at the reporting date, March 31, 2000, no interest is due but this needs to be accrued in the books for reporting purposes:
Calculation:
Accounting Entries:
Dr Accrued Interest Income $500,000.00
Cr Income $500,000.00
(To record NET SWAP Interest Receivable)
Dr Accrued Interest Income $3,500,000.00
Cr Income $3,500,000.00
(To record Bond Interest Income Receivable- accrued on original bond acquired @7% for $200M)
Dr Swap Asset $17,295,993.34
Cr Unrealized holding gain/loss - income $17,295,993.34
(To record increase in FV of Swap Asset)
Change in FV of Bond = $200,000,000 - $186,025,427.3 = $13,974,572.7
Dr Unrealized holding gain/loss - income $13,974,572.7
Cr Bonds $13,974,572.7
(To record decrease in FV of Bond)
INCOME STATEMENT PRESENTATION:
NET SWAP INTEREST INCOME:
Net Interest Income $500,000.00
NET BOND INTEREST INCOME RECEIVABLE:
Accrued Interest Income $3,500,000.00
NET UNREALIZED HOLDING GAINS/LOSSES:
Increase in FV of swap asset $17,295,993.34
Decrease in Bond FV $13,974,572.70
Net Unrealized holding Gain $3,321,420.64
BALANCE SHEET PRESENTATION:
ASSETS:
Swap Assets: $17,295,993.34
Bonds (7% Fixed 24 months) $186,025,427.30
NET SWAP Interest Income Receivable $500,000.00 ($4M - $3.5M)
Bond Interest Income Receivable $3,500,000.00 (accrued on original bond acquired for $200M at 7% fixed after 3 months).
EQUITY SECTION:
Net Unrealized holding gain/loss $3,321,420.64
**Recalculate the FV of swap and bond every reporting period and repeat these entries.
Bibliography:
- Options, Futures and Other Derivatives “Fifth Edition” John C. Hull 2003
- Financial Accounting Standard 133 - AICPA
- Professional Risk Managers Handbook - Financial Instruments & Financial Markets (www.prmia.org)
NOTE: Thanks to our partners at Blackinsey & Company for providing the solution. Blackinsey & Company is a top tier strategy & management consulting outfit based in Washington, DC. This was created under creative commons and is copyleft. The interpretations and analysis presented in this article are purely for pedagogical exercise and Black Herald cannot be held responsible for any error of commission or omission. Thanks for visiting our website. You are always welcome 
.
If you like this article check out:
FAS 91 for Dummies and stay tuned for the following:
- FAS 133 for Dummies
- FAS 91 for Dummies (Sample with Prepayments)
- FIN 46 for Dummies
- FAS 115 for Dummies
- FAS 123(R) For Dummies
Meadowlark Gardens Virginia (Short Video Clip)
July 10, 2009 | Leave a Comment
“The optimist proclaims that we live in the best of all possible worlds, and the pessimist fears this is true” - James Branch Cabell.
WASHINGTON DC - JULY 5, 2009 - In case you have never been to the Meadowlark Gardens in Vienna, VA, our photojournalist TFLASH went to the park last weekend and put together this short video clip for you. The sound bed is soaring from Apple’s GarageBand and the video was shot using 5D Mark II and old canon FD lenses. Hope you enjoy the serenity of the park. Visit the park when you have time and enjoy the beauty of the botanical garden.
List of Petroleum & Exploration Companies in Nigeria (Tabular Format)
July 9, 2009 | 2 Comments
“Africa is Open for Business” - World Bank.
“Nigeria is Open for Business” - Black Herald
WASHINGTON DC - JULY 9, 2009 : Crude oil is the mainstay of the Nigerian economy accounting for about 90% of foreign revenue. Though efforts have been made to diversify the country’s revenue stream, oil still remains the most significant source of income. The list below contains the names of oil exploration companies in Nigeria - both foreign and local companies. The list is still being updated. There are about 1,000 oil companies in Nigeria.
| # | Company | Website/Location |
|---|---|---|
| 1 | Addax Petroleum | http://www.addaxpetroleum.com/operations |
| 2 | Chevron | http://www.chevron.com/countries/nigeria/default.aspx |
| 3 | Conoco Philips | http://www.conocophillips.com/ |
| 4 | Total | http://www.ng.total.com/ |
| 5 | ExxonMobil | http://www.exxonmobilafrica.com/Africa-English/PA/Operations/AF_OP_Nigeria.asp |
| 6 | Hardy Oil & Gas Plc | http://www.hardyoil.com/Assests/nigeria_main.htm |
| 7 | Nexen Inc | http://www.nexeninc.com/Operations/West_Africa/Nigeria.asp |
| 8 | Petrobras | http://www.petrobras.com/ |
| 9 | Shell | http://www.shell.com/home/content/nigeria |
| 10 | Statoil | http://www.statoil.com/ |
| 11 | Afren Energy Resources | http://www.afren.com/default.asp |
| 12 | Camac (Allied Energy Resources) | http://www.camacholdings.com/contact/index.html |
| 13 | Conoil | http://www.conoilplc.com/index-2.html |
| 14 | Equator Exploration Limited | http://www.equatorexploration.com/operations/nigeria.aspx |
| 15 | Express Petroleum & Gas Ltd | 11 Alhaji Babatunde Jose Street Victoria Island (234 1 261-5115) |
| 16 | Dubri Oil Limited | 8 Gabaro Close Victoria Island |
| 17 | Amni International Petroleum Development Company Ltd | http://www.amnipetroleum.com/index.htm |
| 18 | Famfa Oil | http://www.famfa.com/ |
| 19 | Nigerian National Petroleum Corporation | http://www.nnpcgroup.com/ |
| 20 | Nigerian Petroleum Development Company Ltd | http://www.npdc-ng.com/index.php |
| 21 | Oriental Energy Resources Limited | http://www.oriental-er.com/about/index.htm |
| 22 | Pan Ocean Oil Corporation Nigeria | http://www.panoceanoilnigeria.com/ |
| 23 | Sahara Group | http://www.sahara-group.com/index.php |
| 24 | Solgas Petroleum Limited | 27/29 Adeyemo Alakija Street Victoria Island (234 1 262-0651) |
| 25 | South Atlantic Petroleum Ltd | 105B Ajose Adeogun Street Victoria Island (234 1 2625516/7 |
| 26 | Sunlink Petroleum Limited | http://www.sunlinkpetroleum-ng.com/ |
| 27 | Brawal Shipping (Oil) | http://www.brawalshipping.com/brawal/index.php |
| 28 | Intels Services Nigeria | http://www.intelservices.com/ |
| 29 | Ladol | http://www.ladol.com/ |
| 30 | Technip | http://www.technip.com/entities/nigeria/index.htm |
| 31 | Snake Island Integrated Free Zone | http://www.sifreezone.com/ |
| 32 | Department of Petroleum Resources | http://www.dprnigeria.com/home.html |
| 33 | National Petroleum Investment Management Services | http://www.napims.com/ |
| 34 | Nigerian Association of Petroleum Explorationists | http://www.nape.org.ng/ |
| 35 | Petroleum Technology Association of Nigeria | http://www.petan.org/petan/performance.html |
| 36 | CGG Veritas | http://www.cggveritas.com/Contact.aspx?cid=266&lang=1 |
| 37 | First Fossil Nigeria | http://www.firstfossil.com/ |
| 38 | Global Energy Group | http://www.globalenergyco.com/ |
| 39 | Mabon Limited | http://mabonltd.com/ |
| 40 | Petroleum Geo Services | http://www.pgs.com/Data_Library/West-and-South-Africa/Nigeria/ |
| 41 | Schlumberger | http://www.slb.com/content/contact/geomarkets/eca/nga.asp |
| 42 | United Geo Physical | http://www.unitedgeophysical.com/ |
| 43 | Fugro Nigeria Limited | http://www.fugro-prodec.com/ |
| 44 | Survicom | http://survicom.com/ |
| 45 | Ensco Drilling Company (Nigeria) Ltd | 35 Maloney Street Lagos Nigeria |
| 47 | Noble Drilling | http://www.noblecorp.com/Contact/Contact.asp |
| 48 | African Petroleum Oil Field Services | http://www.apoilfields.com/ |
| 49 | Ana Industries Limited | http://www.anaindustries.net/ |
| 50 | MI Swaco | http://www.miswaco.com/Locations/ |
| 51 | Ariboil Company Limited | http://ariboil.com/index.html |
| 52 | BJ Services Company | http://www.bjservices.com/website/GBLocator.nsf |
| 53 | Ciscon | http://www.cisconservices.com/default.html |
| 54 | Expro | http://www.exprogroup.com/index.php?option=com_content&task=view&id=348&Itemid=373 |
| 55 | Kasolute | http://www.kasolute.com/ |
| 56 | Melvon | http://www.melvon-ng.com/home.htm |
| 57 | Oil Data | http://www.oildatainc.com/html/contact_us.html |
| 58 | Oil Test Services | http://www.oiltestng.com/index.htm |
| 59 | Petrolog | http://www.petrologgroup.com/aboutpetrolog.htm |
| 60 | Roxar | http://www.roxar.com/category.php?categoryID=1432 |
| 61 | Sowsco | http://www.sowsco.net/ |
| 62 | Weafri | http://weafriwellservices.com/ |
| 63 | WOG Allied Services Nigeria Ltd | http://www.wog-allied.com/ |
| 64 | Zukus Industries Limited | http://zukus.homestead.com/ |
| 65 | Amosco | http://www.amosco.com/ |
| 66 | Bell Oil & Gas | http://www.belloil.com/ |
| 67 | B.G. Technical Ltd | http://www.bgtechnical.com/ |
| 68 | Drillog Petro-Dynamics Ltd | http://www.drillogpdl.com/ |
| 69 | Emex Systems | http://www.emexsystems.biz/ |
| 70 | Socotherm Group | http://www.socotherm.com/ |
