Question

APPENDIX A Exercise A-2 (Static) Derivatives; interest rate swap; fixed rate debt [LOA-2] On January 1, 2021, 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, 2021, 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. The contract called for cash settlement of the net interest amount quarterly. Floating (LIBOR) settlement rates were 10% at January 1, 8% at March 31, and 6% June 30, 2021. 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. Fair value of interest rate swap Fair value of note payable January 1 0 $ 200,000 March 31 $ 6,472 $ 206,472 June 30 $ 11,394 $ 211,394 Required: 1. Calculate the net cash settlement at March 31 and June 30, 2021. 2. Prepare the journal entries through June 30, 2021, to record the issuance of the note, interest, and necessary adjustments for changes in fair value.

My main question is how would you calculate the value of the change in Fair Value of the interest rate swap? Thanks

How did he get the Values of $6,472 for March 31 & $11,394 for June 30th

Answer 1

Derivatives-Interest Rate Swap

Derivatives: Derivatives are financial securities that “derive their values” (which are determined to buy or sell the underlying asset at a pre-determined price on a selected date), through contracts between two parties from security price indices.

Interest rate swap: The derivatives in which two contractual parties exchange the cash flows (payments or receipts) based on fixed interest rate and floating interest rate, but not the principal amounts are referred to as interest rate swaps

step: 2 of 20

(1)

Determine the net cash settlement as at March 31, 2021:

Step 1: Compute fixed interest receipts.

The fixed interest receipts are calculated by multiplying the notional amount with fixed interest rate and quarter period as shown below:

Notional Amount ($)	Fixed interest Rate	Quarter Period	Fixed Interest Recipts
$200,000	10%	1/4	$5,000

step: 3 of 20

Step 2: Compute floating interest payments.

The floating interest payments are calculated by multiplying the notional amount, floating rate and quarter period as shown below:

Notional Amount ($)	Floating interest Rate	Quarter Period	FloatingInterest Recipts
$200,000	8%	1/4	$4,000

step: 4 of 20

Step 3: Compute net interest receipts (payments).

The net interest receipts is the difference between fixed interest receipts and floating interest payments calculated as under:

Particulars	Amount $
Fixed Interest Receipt	$5,000
Floating Interest Payments	-4000
Net Interest Receipts	$1,000

step: 5 of 20

Note: Refer to steps 1 and 2 for the values and computations of fixed interest receipts and floating interest payments.

step: 6 of 20

Determine the net cash settlement as at June 30, 2021.

Step 1: Compute fixed interest receipts.

The fixed interest receipts are calculated by multiplying the notional amount with fixed interest rate and quarter period as shown below:

Notional Amount ($)	Fixed interest Rate	Quarter Period	Fixed Interest Recipts
$200,000	10%	1/4	$5,000

step: 7 of 20

Step 2: Compute floating interest payments.

The floating interest payments are calculated by multiplying the notional amount, floating rate and quarter period as shown below:

Notional Amount ($)	Floating interest Rate	Quarter Period	Floating Interest Recipts
$200,000	6%	1/4	$3,000

step: 8 of 20

Step 3: Compute net interest receipts (payments).

The net interest receipts is the difference between fixed interest receipts and floating interest payments calculated as under:

Particulars	Amount $
Fixed Interest Receipt	$5,000
Floating Interest Payments	-3000
Net Interest Receipts	$2,000

Note: Refer to steps 1 and 2 for the values and computations of fixed interest receipts and floating interest payments.

step: 9 of 20

(2)

Journalize the transactions from January 1, 2021 through June 301, 2021 in the books of LLB Industries.

Issuance of note:

date	Account Titiles and Explanation	Debit$	Credit $
2021
Jan-01	Cash	200000
	Notes payable		200000
	(To record issue Of note)

step: 10 of 20

Interest expense payment:

date	Account Titiles and Explanation	Debit$	Credit $
2021
Mar-31	Interest Expense	5000
	Cash		5000
	(To record interest expenses payment)

step: 11 of 20

Note: Refer to requirement 1 for interest expense value.

step: 12 of 20

Net interest receipt:

date	Account Titiles and Explanation	Debit$	Credit $
2021
Mar-31	Cash	1000
	Interest Expense		1000
	(To record interest settlement )

step: 13 of 20

Note: Refer to requirement 1 for net interest receipt value.

step: 14 of 20

Changes in fair value of interest swap:

date	Account Titiles and Explanation	Debit$	Credit $
2021
Mar-31	Interest Rate Swap	6472
	Holding gain- interest Swap		6472
	(To record increase in fair value from $0
	to $6472)

step: 15 of 20

Changes in fair value of note:

date	Account Titiles and Explanation	Debit$	Credit $
2021
Mar-31	Holding Loss- Hedged note	6472
	Note Payable		6472
	(To record increase in fair value from
	$200000 to $206472)

step: 16 of 20

date	Account Titiles and Explanation	Debit$	Credit $
2021
Jun-30	Interest Expenses	5000
	Cash		5000
	(To record Interest Expense Payment)

step: 17 of 20

Note: Refer to requirement 1 for interest expense value.

step: 18 of 20

Net interest receipt:

date	Account Titiles and Explanation	Debit$	Credit $
2021
Jun-30	Cash	2000
	Interest Expense		2000
	(To record net Interest Settlement)

Note: Refer to requirement 1 for net interest receipt value.

step: 19 of 20

Changes in fair value of interest swap:

date	Account Titiles and Explanation	Debit$	Credit $
2021
Jun-30	Interest Rate Swap	4922
	Holding Gain- Interest Rate Swap		4922
	(To record Increase in fair value from $6472 to $11394))

step: 20 of 20

Changes in fair value of note:

date	Account Titiles and Explanation	Debit$	Credit $
2021
Jun-30	Holding Loss- hedged Note	4922
	Note Payable		4922
	(To record Increase in fair value from $2006472
	to $211394))