I begin with a chart showing the interest rate fluctuations of mortgages in 1999

An Interactive Sensitivity Analysis of Example 2 in FAS 133

Bob Jensen at Trinity University

Example 2 is located in FAS 133 entitled Accounting for Derivative Instruments and Hedging Activities (ISSN 0885-9051, Product Code S133, Financial Accounting Standards Board, P.O. Box 5116, Norwalk, CN, 1998, pp. 61-67).

If you want to see my complete Excel workbook on Example 2, go to http://www.trinity.edu/rjensen/caseans/133ex02a.xls
It is best to download the complete workbook and run it in Excel rather than in your web browser.
Trinity University students may download the complete workbook from
J:\courses\acct5341\answers\xls\133ex02a.xls

A glossary and links to overview documents can be found at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm

Table of Contents

Introduction
Effective Hedge Case
Ineffective Hedge Case

Introduction

I begin with a chart showing the interest rate fluctuations of mortgages in 1999. The source of the graph below is http://www.reginvest.com/history.htm.

The "fair value" of a mortgage is a flipped image. For example, when mortgage rates bottomed out in October of 1999, the market price for any mortgage note or bond will have its highest value in October relative to any other month in 1999. The borrower still has to pay back the amortized historical cost of the loan, but it makes economic sense to buy back the fixed-rate debt in a period of lower interest rates. If the contract is traded in a market, the borrower may want to cancel the fixed-rate debt and refinance the loan in periods of very low interest rates.

Another way to view this situation is to think of the bond market. Bonds are sold as percentages of face value. For example, the price of a $1,000 bond that is quoted at 94.50 will sell for $945 at a discount 5.50% = 100%-94.50%. If interest rates fall to 5.00%, the value of the bond rises to $950. Similarly, a rise in interest rates to 6.00% the value of the bond drops to $940. During periods of plunging interest rates, borrowers often buy back their bonds payable.

It would seem that ABC Company wanted to reduce the net refinancing costs of its debt if interest rates plunge. If interest rates plunge it is tempting to buy back the bonds and refinance at lower rates. For example, in times of plunging interest rates Exxon Corporation has been known to enter the market to buy back its own debt. However, if interest rates plunge, the fair values of the bonds soar so that it may be very expensive to buy back the debt at market values. The swap hedge fixes the net cost of calling back the debt at $1,000,000. This must be what ABC Company wants if it predicts plunging LIBOR rates. Of course in real life it may not be so simple. Debt may have call back provisions that are not equal to current market value. And, as in the case of mortgages, there my be significant transactions costs that prevent refinancing for small declines in interest rates. It will be assumed that ABC Company adjusts debt to fair value using a contra account called Unrealized Fair Value Adjustment of Debt. Gains and losses in value that are not effectively hedged are assumed to be charged to Other Comprehensive Income (OCI). Under FAS 133, gains and losses on a fair market hedging derivative are charged to current earnings. The OCI account is discussed in FAS 130. The accounting for debt that is intended to be terminated early is analogous to investments classified as Available for Sale under FAS 115.

Another way to view this situation is to think of the bond market. Bonds are sold as percentages of face value. For example, the price of a $1,000 bond that is quoted at 94.50 will sell for $945 at a discount 5.50% = 100%-94.50%. If interest rates fall to 5.00%, the value of the bond rises to $950. Similarly, a rise in interest rates to 6.00% the valueof the bond drops to $940. During periods of plunging interest rates, borrowers often buy back their bonds payable.

An Interactive Spreadsheet for an Effective Fair Value Hedge
Students may, however, change the LIBOR spot rate patterns to study the differences between rising interest rates versus falling interest rates on the interest rate swap hedge outcomes.

Warning 1 The interactive spreadsheet below will probably not work properly unless you have Microsoft Office 2000 installed on your computer and are using Internet Explorer Version 5.0 or higher. Instructions for downloading the Excel workbook are given at the bottom of the page.

Warning 2: Spot rates should be entered as proportions if you do a sensitivity analysis of interest rate patterns.

An Interactive Spreadsheet for an Ineffective Fair Value Hedge
Students may change the LIBOR spot rate patterns, debt value patterns, and yield curve patterns to study the sensitivity of the interest rate swap hedge outcomes under different patterns of ineffective hedges and nonlinear yield curves.

Warning 1: The interactive spreadsheet below will probably not work properly unless you have Microsoft Office 2000 installed on your computer and are using Internet Explorer Version 5.0 or higher. Instructions for downloading the Excel workbook are given at the bottom of the page.

Warning 2: Debt fair values should be entered as negative numbers. Spot rates and yield factors should be entered as proportions.