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Financial Instruments - Hedging Handout 1: Recap Questions

T-Shirt Corp enters into various hedging transactions to mitigate risks from fluctuations in interest rates and foreign exchange rates. For an interest rate swap where T-Shirt Corp receives a variable rate and pays a fixed rate, the changes in fair value of the swap are initially recognized in equity and subsequently in the income statement when interest on the hedged bond is accrued. For a forward exchange contract hedging a future equipment purchase, changes in fair value are also initially recognized in equity as part of hedge accounting, with the reserve balance impacting the asset purchased.

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61 views3 pages

Financial Instruments - Hedging Handout 1: Recap Questions

T-Shirt Corp enters into various hedging transactions to mitigate risks from fluctuations in interest rates and foreign exchange rates. For an interest rate swap where T-Shirt Corp receives a variable rate and pays a fixed rate, the changes in fair value of the swap are initially recognized in equity and subsequently in the income statement when interest on the hedged bond is accrued. For a forward exchange contract hedging a future equipment purchase, changes in fair value are also initially recognized in equity as part of hedge accounting, with the reserve balance impacting the asset purchased.

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Financial Instruments – Hedging

Handout 1

Recap Questions

Question 1

T-Shirt Corp has issued a variable rate bond with interest at 1 month SV$ LIBOR plus
3%, therefore cash flows will vary with interest rates. T-Shirt Corp enters into an interest
rate swap to receive LIBOR and pay 5% fixed for 3 years.

Assuming that LIBOR is fixed at 4% for the first month, what is the interest rate payable
on the bond before and after the swap is taken out?

(a) 6% before and 8% after


(b) 7% before and 8% after
(c) 7% before and 6% after

Question 2

T-Shirt Corp has issued a variable rate bond with interest at 1 month SV$ LIBOR plus
3%; therefore cash flows will vary with interest rates. T-Shirt Corp enters into an interest
rate swap to receive LIBOR and pay 5% fixed for 3 years.

Assuming that all the conditions for hedge accounting are met, where are changes in fair
value of the swap recognised?

a) Income statement
b) Equity
c) Initially in equity, and to the income statement when interest on the bond is
accrued

Question 3

T-Shirt Corp has issued a fixed rate bond with interest at 4% (therefore cash flows will
not vary with interest rates). T-Shirt Corp enters into an interest rate swap to pay 1 month
LIBOR and receive 4% fixed for 3 years.

Assuming that LIBOR is 5% and subsequently 3%, the fair value of the swap will be
respectively:

a) Positive with LIBOR at 5% and negative with LIBOR at 3%


b) Negative with LIBOR at 5% and positive with LIBOR at 3%

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Financial Instruments – Hedging

Handout 1

Question 4

a) T-Shirt Corp enters into a forward exchange contract to purchase Euros and pay
SV$. The contract is intended to hedge a future purchase of plant from a German
supplier.

Key dates

30 September 20XX Equipment is ordered (price of €1m)


30 September 20XX Forward exchange contract taken out
31 May 20YY Delivery of equipment
30 June 20YY Payment

The forward contract is to receive €1m in exchange for a payment of SV$810,000 on 30


June 20YY at a forward rate of 0.81. Exchange rates over the life of the transaction are
as follows:

Date Spot rate Forward exchange rate (30


June 20YY)
30 September 20XX 0.82 0.81
31 December 20XX 0.81 0.805
31 May 20YY 0.80 0.79
30 June 20YY 0.78 N/A

Assuming hedge accounting is achieved, what is the journal entry required for the
derivative on 31 March 20XX when the equipment is delivered?

a) DR PPE SV$20,000, CR Hedging reserve SV$20,000


b) DR Income statement SV$20,000, CR Hedging reserve SV$20,000
c) DR Hedging reserve SV$20,000, CR Liabilities SV$20,000

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Financial Instruments – Hedging

Handout 1

Question 5

T-Shirt Corp has issued a fixed rate bond with interest at 4% (therefore cash flows will
not vary with interest rates). T-Shirt Corp enters into an interest rate swap to pay 1 month
LIBOR and receive 4% fixed for 3 years. All the conditions for hedge accounting are
met.

Where are changes in fair value of the swap recognised?

a) Income statement
b) Equity
c) Initially in equity, and to income statement when interest on the bond is accrued

Question 6

T-Shirt Corp, expects to sell 100,000 T-shirts to a regular Dutch customer in the
Netherlands for NLG 10,000,000 for cash settlement on 31 March 20YY. The sale is
highly probable. On 30 September 20XX T-Shirt Corp enters into a foreign currency
forward contract to sell NLG 10,000,000 on 31 March 20YY at the forward rate of 1SV$
= 2NLG. The hedge is properly designated and qualifies for hedge accounting.

How does T-Shirt Corp recognise fair value changes in the hedging instrument before the
sale occurs?

a) In the income statement


b) Within a separate reserve in equity
c) In this case the derivative is carried at cost

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