FAS 133 for Dummies - Accounting for Equity Swaps (Part II)
January 31, 2010 | 1 Comment
“There are two types of people in this world - the taker and the taken. The taker who takes the most is the richest. “ - P. Diddy in the ABC Drama, A Raisin in the Sun.
NEWENTRY llc entered into a 2 year fixed-rate equity swap as follows:
- The aim of this exercise is to illustrate how to account for an equity swap designated as a fair value hedge.
- However, how can you account for something if you don’t really know how it is valued?
- There is usually independence between accounting and pricing/valuation (one should at least hope so), however, the accountants should at least understand what is happening under the hood.
- Notional is 100M USD.
- Trade date is March 31, 2008.
- Newentry llc is the fixed-rate receiver.
- The fixed rate will be calculated based on market information (see below). This is called “Pricing the Swap”.
- The swap will have payment dates as follows: (a) September 30, 2008 (b) March 31, 2009 (c) September 30, 2009 and (d) March 31, 2010.
- The days to maturity for these payment dates as March 31, 2008 as follows: (a) September 30, 2008 - 183 days (b) March 31, 2009 - 365 days (c) September 30, 2009 and - 548 days(d) March 31, 2010 730 days.
- The term structure of interest rate (LIBOR) on the payment dates as observed on March 31, 2008 were as follows (a) September 30, 2008 - 4.75% (b) March 31, 2009 - 4.85% (c) September 30, 2009 - 5.23% and (d) March 31, 2010 - 5.45%.
- Assume a 30/360 date convention.
- Ignore dividend and taxation.
- Also ignore transaction costs.
- The stock index “NASDAQ 1000″ on March 31, 2008 was 2002.
- Newentry’s reporting date is June 30, 2008 and the “NASDAQ 1000″index on that date was 1750.
- NASDAQ 1000 was 1770 on first payment date September 30, 2008, the first payment date
- The term structure of interest rate (LIBOR) on the payment dates as observed on June 30 2008 were as follows (a) September 30, 2008 - 4.95% (b) March 31, 2009 - 4.99% (c) September 30, 2009 - 5.29% and (d) March 31, 2010 - 5.55%.
- The days to maturity for these payment dates as June 30, 2008 as follows: (a) September 30, 2008 - 92 days (b) March 31, 2009 - 274 days (c) September 30, 2009 and - 457 days(d) March 31, 2010 - 639 days.
Valuation of the Fixed-Rate Equity Swap:
- Value of the swap at inception is zero as with any other type of swap. As you move towards maturity this value changes depending on the volatility of the underlying and changes in interest rate.
- For a fixed rate equity swap. The “Fixed Rate” on the initiation date should be established - “Pricing the Swap”..
Calculation of Fixed Rate:
First we must determine the discount factors as of March 31, 2008 for 183, 365, 548 and 730 days as follows:
(a) B (B,183) = 1/ (1+0.0475(183/360)) = 0.9764
(b) B (B,365) = 1/ (1+0.0485(365/360)) = 0.9531
(c) B (B,548) = 1/ (1+0.0523(548/360)) = 0.9262
(d) B (B,730) = 1/ (1+0.0545(730/360)) = 0.9004
Using the formula below: R = 1 - B(0,t + n) / Sum of B(0, t + i)
R = The fixed rate on the swap = (Price of the swap not the value).
B (0, t +n ) = Discount factor on the last payment date.
Sum of B (0, t + i ) = Sum of discount factors for all payment dates.
R = (1 - 0.9764)/(0.9764 + 0.9531 + 0.9262 + 0.9004) = (1 - 0.9764)/(3.7561) = 0.006283.
Thus the fixed payment is $0.006283 per $1 of notional.
Then we must determine the discount factors as of June 30, 2008 for 92, 274, 457 and 639 days as follows:
(a) B (B,92) = 1/ (1+0.0495(92/360)) = 0.98750
(b) B (B,274) = 1/ (1+0.0499(274/360)) = 0.9634
(c) B (B,457) = 1/ (1+0.0529(457/360)) = 0.9370
(d) B (B,639) = 1/ (1+0.0555(639/360)) = 0.9103
Valuation of the fixed-rate swap on June 30, 2008:
From a fixed-rate receiver perspective:
V = B(j, t + n) - R (sum of B(j,t + 1) - (S (j)/S(0))
V = Value of the swap at a point in time.
B (0, t +n ) = Discount factor on the last payment date.
Sum of B (0, t + i ) = Sum of discount factors for all payment dates.
V = 0.9103 - 0.006283 ( 0.98750 + 0.9634 + 0.9370 + 0.9103 ) - ((1750/2002)) = $0.123100353/$1 notional principal.
ACCOUNTING ENTRIES - June 30, 2008:
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.
As of June 30, 2008 - Mark to Market Adjustment Resulting from a decline in the “NASDAQ 1000″ is ($1750/2002) -1 * 100M = ($12,587,412.59).
Dr Earnings - Unrealized Holding Gains - $12,587,412.59
Cr - Equity Investments - $12,587,412.59.
(To record the mark-to-market adjustments on the $100M investments in the NASDAQ 1000 as June 30, 2008)
Dr. Swap Asset (0.123100353 * 100M) - $12,310,035.3
Cr - Earnings - Unrealized Gains - - $12,310,035.3.
(To record increase in value of equity swap as of June 30, 2008)
Balance Sheet Presentation as of June 30, 2008:
Equity Investments $100,000,000.00
Fair Value Adjustments ($12,587,412.59)
Net 87, 412,587.41
Swap Assets $12,310,035.3
Unrealized Holding Gain - 12,310,035.3.
Fair Value Adjustments - ($12,587,412.59)
Net loss ( $277,377.29)
Note that no payments are due until September 30, 2008 on the equity swap. However, you should consider accruing and recording the anticipated receivable asset or liability on this date. See below for calculation of net settlement on the first payment date
Calculation of Net Settlements at Payment periods (Note that payment is not due until September 30, 2008):
Assume that the NASDAQ 1000 index is at 1770 on September 30, 2008:
Payment based on equity index = (1770/2002) - 1 * 100M = ($11,588,411.59)
Note that this is a depreciation. The fixed rate receiver - Newentry llc ( who normally pays appreciation in the index) gets the depreciation in addition to the fixed payment.
Fixed payment to be received is 0.006283 * 100,000,000 = $628,300.00
Total payment to be received = $11,588,411.59 + 628,300.00 = $12,216,711.59
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)
- Professor Don Chance - Louisiana State University - Equity Swaps & Equity Investing
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
Martin Luther King Day 2010
January 18, 2010 | Leave a Comment
WASHINGTON DC - January 18, 2010 - Today is Martin Luther King Day and we are proud to bring you the text of the speech he made to a civil rights rally on the National Mall in Washington in 1963.
******************************************************************************************
I am happy to join with you today in what will go down in history as the greatest demonstration for freedom in the history of our nation.
Five score years ago, a great American, in whose symbolic shadow we stand today, signed the Emancipation Proclamation. This momentous decree came as a great beacon light of hope to millions of Negro slaves who had been seared in the flames of withering injustice. It came as a joyous daybreak to end the long night of their captivity.
But one hundred years later, the Negro still is not free. One hundred years later, the life of the Negro is still sadly crippled by the manacles of segregation and the chains of discrimination. One hundred years later, the Negro lives on a lonely island of poverty in the midst of a vast ocean of material prosperity. One hundred years later, the Negro is still languishing in the corners of American society and finds himself an exile in his own land. So we have come here today to dramatize a shameful condition.
In a sense we have come to our nation’s capital to cash a check. When the architects of our republic wrote the magnificent words of the Constitution and the Declaration of Independence, they were signing a promissory note to which every American was to fall heir. This note was a promise that all men, yes, black men as well as white men, would be guaranteed the unalienable rights of life, liberty, and the pursuit of happiness.
It is obvious today that America has defaulted on this promissory note insofar as her citizens of color are concerned. Instead of honoring this sacred obligation, America has given the Negro people a bad check, a check which has come back marked “insufficient funds.” But we refuse to believe that the bank of justice is bankrupt. We refuse to believe that there are insufficient funds in the great vaults of opportunity of this nation. So we have come to cash this check — a check that will give us upon demand the riches of freedom and the security of justice. We have also come to this hallowed spot to remind America of the fierce urgency of now. This is no time to engage in the luxury of cooling off or to take the tranquilizing drug of gradualism. Now is the time to make real the promises of democracy. Now is the time to rise from the dark and desolate valley of segregation to the sunlit path of racial justice. Now is the time to lift our nation from the quick sands of racial injustice to the solid rock of brotherhood. Now is the time to make justice a reality for all of God’s children.
It would be fatal for the nation to overlook the urgency of the moment. This sweltering summer of the Negro’s legitimate discontent will not pass until there is an invigorating autumn of freedom and equality. Nineteen sixty-three is not an end, but a beginning. Those who hope that the Negro needed to blow off steam and will now be content will have a rude awakening if the nation returns to business as usual. There will be neither rest nor tranquility in America until the Negro is granted his citizenship rights. The whirlwinds of revolt will continue to shake the foundations of our nation until the bright day of justice emerges.
But there is something that I must say to my people who stand on the warm threshold which leads into the palace of justice. In the process of gaining our rightful place we must not be guilty of wrongful deeds. Let us not seek to satisfy our thirst for freedom by drinking from the cup of bitterness and hatred.
We must forever conduct our struggle on the high plane of dignity and discipline. We must not allow our creative protest to degenerate into physical violence. Again and again we must rise to the majestic heights of meeting physical force with soul force. The marvelous new militancy which has engulfed the Negro community must not lead us to a distrust of all white people, for many of our white brothers, as evidenced by their presence here today, have come to realize that their destiny is tied up with our destiny. They have come to realize that their freedom is inextricably bound to our freedom. We cannot walk alone.
As we walk, we must make the pledge that we shall always march ahead. We cannot turn back. There are those who are asking the devotees of civil rights, “When will you be satisfied?” We can never be satisfied as long as the Negro is the victim of the unspeakable horrors of police brutality. We can never be satisfied, as long as our bodies, heavy with the fatigue of travel, cannot gain lodging in the motels of the highways and the hotels of the cities. We cannot be satisfied as long as the Negro’s basic mobility is from a smaller ghetto to a larger one. We can never be satisfied as long as our children are stripped of their selfhood and robbed of their dignity by signs stating “For Whites Only”. We cannot be satisfied as long as a Negro in Mississippi cannot vote and a Negro in New York believes he has nothing for which to vote. No, no, we are not satisfied, and we will not be satisfied until justice rolls down like waters and righteousness like a mighty stream.
I am not unmindful that some of you have come here out of great trials and tribulations. Some of you have come fresh from narrow jail cells. Some of you have come from areas where your quest for freedom left you battered by the storms of persecution and staggered by the winds of police brutality. You have been the veterans of creative suffering. Continue to work with the faith that unearned suffering is redemptive.
Go back to Mississippi, go back to Alabama, go back to South Carolina, go back to Georgia, go back to Louisiana, go back to the slums and ghettos of our northern cities, knowing that somehow this situation can and will be changed. Let us not wallow in the valley of despair.
I say to you today, my friends, so even though we face the difficulties of today and tomorrow, I still have a dream. It is a dream deeply rooted in the American dream.
I have a dream that one day this nation will rise up and live out the true meaning of its creed: “We hold these truths to be self-evident: that all men are created equal.”
I have a dream that one day on the red hills of Georgia the sons of former slaves and the sons of former slave owners will be able to sit down together at the table of brotherhood.
I have a dream that one day even the state of Mississippi, a state sweltering with the heat of injustice, sweltering with the heat of oppression, will be transformed into an oasis of freedom and justice.
I have a dream that my four little children will one day live in a nation where they will not be judged by the color of their skin but by the content of their character.
I have a dream today.
I have a dream that one day, down in Alabama, with its vicious racists, with its governor having his lips dripping with the words of interposition and nullification; one day right there in Alabama, little black boys and black girls will be able to join hands with little white boys and white girls as sisters and brothers.
I have a dream today.
I have a dream that one day every valley shall be exalted, every hill and mountain shall be made low, the rough places will be made plain, and the crooked places will be made straight, and the glory of the Lord shall be revealed, and all flesh shall see it together.
This is our hope. This is the faith that I go back to the South with. With this faith we will be able to hew out of the mountain of despair a stone of hope. With this faith we will be able to transform the jangling discords of our nation into a beautiful symphony of brotherhood. With this faith we will be able to work together, to pray together, to struggle together, to go to jail together, to stand up for freedom together, knowing that we will be free one day.
This will be the day when all of God’s children will be able to sing with a new meaning, “My country, ’tis of thee, sweet land of liberty, of thee I sing. Land where my fathers died, land of the pilgrim’s pride, from every mountainside, let freedom ring.”
And if America is to be a great nation this must become true. So let freedom ring from the prodigious hilltops of New Hampshire. Let freedom ring from the mighty mountains of New York. Let freedom ring from the heightening Alleghenies of Pennsylvania!
Let freedom ring from the snowcapped Rockies of Colorado!
Let freedom ring from the curvaceous slopes of California!
But not only that; let freedom ring from Stone Mountain of Georgia!
Let freedom ring from Lookout Mountain of Tennessee!
Let freedom ring from every hill and molehill of Mississippi. From every mountainside, let freedom ring.
And when this happens, when we allow freedom to ring, when we let it ring from every village and every hamlet, from every state and every city, we will be able to speed up that day when all of God’s children, black men and white men, Jews and Gentiles, Protestants and Catholics, will be able to join hands and sing in the words of the old Negro spiritual, “Free at last! free at last! thank God Almighty, we are free at last!”
Happy New Year!!!
January 4, 2010 | Leave a Comment
Dear friends, it is a new day and it is a new year. It is the beginning of a new dawn and in 2010 Black Herald wishes you all the best that the new year can bring..more joy, more happiness, more money, good health etc. 2009 was a good year but 2010 is even going to be better. Once again happy new year and best wishes for success!!
