FAS 133 - Accounting For Equity Swap

August 21, 2009

“Until lions have their historians, tales of the hunt shall always glorify the hunter” - African Proverb

equity_swap

See FAS 133 for Dummies - Accounting for Equity Swaps Part 2 is now available.

WILDHORSES PENSION FUND holds an equity portfolio of $350,000,000 that mirrors the Dow Jones Industrial Index.   Concerned that interest rate may rise in the near future, causing a reduction in money supply and consequent movement of capital out the equity market (adverse price movement in the equity market), the Chief Risk Officer (CRO) of WILDHORSES PENSION FUND, TFLASH entered into an equity swap to receive LIBOR minus 15 basis point spread.  The following key information are pertinent to the contract.

  • The length of the swap agreement is 6 months.
  • Date Convention is Actual/360 and a six month period is assumed to be 180 days.
  • The swap contract was entered into on January 1, 2008
  • Dividend Yield is 3%.
  • Six month LIBOR is 6% per annum (Constant Rate)
  • Transaction Cost is Zero
  • On June 30th 2008, Dow Jone Index dropped by 8.8%.

VALUATION & CASH FLOW CALCULATION:

  • The buyer of an equity swap pays the appreciation in the value of the index plus any dividend.
  • The seller of an equity swap pays the depreciation in the value of the index plus LIBOR minus spread.
  • The actual valuation of the underlying portfolio is very easy and its just a multiplication of the portfolio value (notional) by (1 - Percentage (%)) drop in the Index.
  • Note that an equity swap is worth zero immediately after each reset date.  However, what if your reporting period is between reset dates. How will you value an equity swap between payment dates ?   Basically, if you pay some interest rate to recieve the equity then the interim value between resets is the difference between the relative equity price and the discounted interest payment. This will be discussed in a future series.  This example assumes that the reporting period coincides with the payment dates.

So on June 30th, 2008 (six months later) our numbers are calculated as follows:

From the perspective of Wildhorses Pension Fund -

INFLOW:
Notional = $350,000,000.00
Depreciation Percentage = 8.8%
LIBOR - Spread = 6% - (15/100)% = 5.85%
Inflow = (Notional * Depreciation) + Notional * LIBOR -Spread * (180/360)  =
($350,000,000 * 0.088) + $350,000,000 *5.85%*(180/360) =
30,800,000.00 + 10,237,500.00 =  $41,037,500.00

OUTFLOW:

Outflow = Notional* Price Appreciation + Notional*Dividends

$350,000,000* 0 + $350,000,000 * 0.03 * (180/360) = $5,250,000.00

NET INFLOW = $41,037,500.00 - $5,250,000.00 = $35,787,500.00

EQUITY PORTFOLIO:
Value as of June 30, 2008 = $350,000,000 * (1-0.088) = $319,200,000.00

Decrease in Fair Value = $350,000,000.00 - $319,200,000.00 = $30,800,000.00

ACCOUNTING:

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.

*This is a fair value hedge and as you can tell, we are hedging the risk of adverse movement in price of the portfolio.

Day 1:  No accounting entries required just memorandum entries.  Swap value is zero at inception.

This contract has expired or reached maturity after six months hence entries are posted as follows to reflect this transaction on June 30, 2008:

Dr Unrealized Holding Gain/Loss (Income Statement)   $30,800,000.00
Cr Equity Portfolio                                                                            $30,800,00.00

(To record decrease in fair value of equity - mark to market)

Dr Cash  (Net Cash Inflow)   $35,787,500.00
Cr  Income Statement (Swap Pay-Off)    $35,787,500.00

(To record net swap income as of June 30, 2008)

INCOME STATEMENT PRESENTATION:
Unrealized Holding Loss:              ($30,800,000.00)
Swap Payment Received                 $35,787,500.00
Net Income Impact                         $4,987,500.00

BALANCE SHEET:
Equity Portfolio                           $319,200,000.00

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)
  • Pricing, Hedging & Trading Financial Instruments - Carol Alexander
  • Quantitative Methods in Finance - Carol Alexander

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

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