Working Paper 231 Exhibits

Bob Jensen at Trinity University

Table of Contents

Exhibit 1: A Vanilla Swap Illustration (Assume Transactions are Hedges)

Exhibit 2: Comparisons of Methods 2 and 4 Current Present Value Swap Receivables/Payables [Bond + Swap] Versus Legal Settlement Amortization (Discount) Rates

Exhibit 3: Comparisons of Methods 3 and 5 Historical Cost Swap Receivables/Payables [Bond + Swap] Versus Legal Settlement Amortization (Discount) Rates

Exhibit 4: Impact of Interest Rate Swap on Net Income Under All Accounting Methods

Exhibit 5: Driver Sensitivity Analysis Notional Bond/Note Interest Payments Net of Swap Payments

Exhibit 1
A Vanilla Swap Illustration for Working Paper 231
(Assume the Swap is a Cash Flow Hedge for Company B)

Bob Jensen at Trinity University

Terminology is defined in Bob Jensen’s free online web version of "SFAS 133 Glossary and Transcriptions of Experts on Accounting for Derivative Instruments and Hedging Activities" at http://www.trinity.edu/rjensen/133glosf.htm

LIBOR = the current London InterBank Offering Rate that banks can borrow at in London. Assume that LIBOR increases ex post by 0.5% on December 31 each year for years t= 2, 3, 4, 5, 6, and 7. At January 1, 19x1 and December 31, 19x1 LIBOR = 8.0%.

Let Time t depict year t except when t=0 depicts January 1 of year 1. The swap agreement commences at t=0.

Assume LIBOR changes on December 31 of each year commencing with Year 2. It changes to 8.5% on December 31, 19x2, 9.0% on December 31 19x3, etc. The r(t) and p(t) rates and resulting X(t) swap cash payments are all ex post after announced LIBOR changes on December 31. At December 31, 19xt, the ex ante t+1 LIBOR rate is not yet known for accounting purposes. Estimates of amortization rates and future swap cash flows are required using only ex post information known through December 31 of the year in question. In other words, the ex ante LIBOR estimages at times t+1 through n are to be the ex post LIBOR at time t.

Company A has a high credit rating and can borrow at a fixed rate of 9.5% or a floating rate at LIBOR plus 1.0 %. After signing a swap agreement, Company A borrows $10 million at 9.5 % fixed rate on bonds issued at par for a seven year term. Assume the swap counts as a hedge against another transaction.

Company B can borrow at a fixed rate of 11.5 % or a floating rate of LIBOR plus 1.5 %. Company B would have paid the 11.5% fixed, but after a swap agreement that eliminated interest rate risk exposure, Company B borrows $ 10 million at LIBOR plus 1.5 % floating rate on a seven year note. Assume the swap counts as a hedge against some other transaction.

Company A estimates that LIBOR will not rise above 9.5% over the next seven years. Company B would like to borrow $10 million at lower rates that its options given above. Although Company A has a rate advantage over Company B on both fixed and variable rates, its comparative advantage of 2% on the fixed borrowing rate is better than its comparative advantage on floating rates.

Companies A and B enter into a matched swap agreement in which they both borrow $10 million and swap interest rates. Company A borrows at a 9.5% rate and Company B borrows at LIBOR + 1.5%. Both continue to service their own loans and agree to pay back their own loans. Company B agrees to pay a swap rate of 11% fixed, which is less than the 11.5% fixed rate it must pay without an interest rate swap. Company A pays LIBOR + 1.5% which is more than the variable rate of LIBOR + 1.0% it can obtain without the swap.

This is a private swap contract with no intervening broker and no transactions fees. The parameters for Equations (1) through (9) are as follows:

Exhibit 2

Comparisons of Methods 2 and 4

Current Present Value Swap Receivables/Payables

[Bond + Swap] Versus Legal Settlement Amortization (Discount) Rates

Exhibit 3

Comparisons of Methods 3 and 5

Historical Cost Swap Receivables/Payables

[Bond + Swap] Versus Legal Settlement Amortization (Discount) Rates

Exhibit 4

Impact of Interest Rate Swap on Net Income

Under All Accounting Methods

Exhibit 5

Driver Sensitivity Analysis

Notional Bond/Note Interest Payments Net

of Swap Payments

As Functions of Changes in the LIBOR Index

Note how Company B has swapped out of all risk of LIBOR increases even though its notional $10 million note has a variable interest rate that increases with LIBOR increases. The interest rate swap eliminated the Company B LIBOR risk.

Company A's risk increases $100,000 with each 1.0% increase in LIBOR. Company A had no LIBOR risk until the interest rate swap with Company B. Company A benefits from the swap only if LIBOR does not rise above 11.0%.