On January 1, 2011, Cam borrows $400,000 from Ven. The five-year term note is a variable-rate one in which the 2011 interest rate is determined to be 8 percent, the LIBOR rate at January 1, 2011, +2%. Subsequent years’ interest rates are determined in a similar manner, with the rate set for a particular year equal to the beginning-of-the-year LIBOR rate +2 percent. Interest payments are due on December 31 each year and are computed assuming annual compounding.
Also on January 1, 2011, Cam decides to enter into a pay-fixed, receive-variable interest rate swap arrangement with Gra. Cam will pay 8 percent.
Assume that the LIBOR rate on December 31, 2011, is 5 percent.
1. Why is this considered a cash-flow hedge instead of a fair-value hedge?
2. Do you think that this hedge would be considered effective and therefore would qualify for hedge accounting?
3. Assuming that this hedge relationship qualifies for hedge accounting:
a. Determine the estimated fair value of the hedge at December 31, 2011. Recall that the hedge contract is in effect for the 2012, 2013, 2014, and 2015 interest payments.
b. Prepare the entry at December 31, 2011, to account for this cash-flow hedge as well as the December 31, 2011, interest payment.
4. Assuming that the LIBOR rate is 5.5 percent on December 31, 2012, prepare all the necessary entries to account for the interest rate swap at December 31, 2012, including the 2012 interest payment.
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