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CASE 7 - Cash Flow Hedge of Forecasted Treasury Note Purchase

CASE 7 - Cash Flow Hedge of Forecasted Treasury Note Purchase. On 1/1/X1, XYZ forecasts a 12/31/X1 purchase of $100 million 5-year 6% Treasury notes to be classified AFS At 1/1/X1 the 1-year forward rate for 5-year Treasury notes is 6 %

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CASE 7 - Cash Flow Hedge of Forecasted Treasury Note Purchase

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  1. CASE 7 - Cash Flow Hedge of Forecasted Treasury Note Purchase • On 1/1/X1, XYZ forecasts a 12/31/X1 purchase of $100 million 5-year 6% Treasury notes to be classified AFS • At 1/1/X1 the 1-year forward rate for 5-year Treasury notes is 6 % • XYZ wants to lock in at least the 6% yield for the $100 million Treasury note purchase • XYZ’s hedge strategy is to purchase a call option on $100 million of the 5-year Treasury notes that have a 6% 1-year forward rate

  2. CASE 7 - Cash Flow Hedge of ForecastedTreasury Note Purchase • XYZ specified that hedge effectiveness will be measured based on the total price change of the Treasury notes and the intrinsic value of the option (zero at 1/1/X1) • The American call option purchased at 1/1/X1 has a 1-year term • The call premium is $1.4 million, the strike rate is 6%, and the option is currently at-the-money

  3. CASE 7 - Cash Flow Hedge of ForecastedTreasury Note Purchase On 1/1/X1, the following activity is recorded: Call option asset 1,400,000 Cash 1,400,000 To record the option purchase

  4. CASE 7 - Cash Flow Hedge of ForecastedTreasury Note Purchase At 6/30/X1, the 12/31X1 forward 5-year Treasury rate has declined 100 basis points from 6% to 5% and the market price is 104.376. The following entry is recorded to reflect the increase in the call option’s intrinsic value. Call option asset 4,376,000 OCI 4,376,000 To record the call option’s intrinsic value (assuming a price of 104.376, calculated as $500,000 annuity received for 10 semiannual periods discounted at 5% = $4,376,000).

  5. CASE 7 - Cash Flow Hedge of ForecastedTreasury Note Purchase (continued) At 6/30/X1, XYZ also determines that the call option’s time value has decreased Earnings 800,000 Call option asset 800,000 To record call option’s time value decrease

  6. CASE 7 - Cash Flow Hedge of ForecastedTreasury Note Purchase At 12/31/X1, XYZ exercises the option and takes delivery of the Treasury notes: Earnings 600,000 Call option asset 600,000 To write off option time value balance Treasury notes 100,000,000 Cash 100,000,000 Treasury notes (premium) 4,376,000 Call option asset 4,376,000 To record exercise of option

  7. CASE 7 - Cash Flow Hedge of ForecastedTreasury Note Purchase • The 12/31/X1 OCI balance of $4,376,000 is reclassified into earnings over the life of the bond. The interest method is used to calculate the periodic amount reclassified into earnings. • The $4,376,000 Treasury note premium is amortized over the life of the bond and offsets the above OCI impact. • On a cash flow and earnings basis, XYZ succeeded in locking in a minimum 6% return on the Treasury notes as if these were purchased at par.

  8. CASE 7 - Cash Flow Hedge of ForecastedTreasury Note Purchase XYZ demonstrates that the hedge was effective as follows: Price of a 6% bond purchased in a 5% rate environment $104,376,000 Less call option proceeds (4,376,000) Net price $100,000,000

  9. CASE 7 - Cash Flow Hedge of ForecastedTreasury Note Purchase If XYZ sold the $100 million bond on 6/30/X2, the remaining OCI balance is reclassified into earnings because the hedged item no longer affects earnings.

  10. CASE 8 Fair Value Hedge of AFS Security • XYZ owns 1,000 shares of ABC worth $100 each ($100,000) • XYZ wants to hedge downside price risk • On 1/1/X1, XYZ purchases an at-the-money put option on 1,000 ABC shares expiring in 6 months; exercise price is $100; option premium is $15,000 • Effectiveness is measured by comparing decreases in fair value of investment with intrinsic value of option

  11. CASE 8Fair Value Hedge of AFS Security Value at Value at Gain/ 1/1/X1 3/31/X1 (Loss) ABC Shares $100,000 $ 98,000 ($ 2,000) Put Option: Intrinsic value $ 0 $ 2,000 $ 2,000 Time value 15,000 8,000 (7,000) Total $ 15,000 $ 10,000 ($ 5,000) Note: The time value of the option includes the volatility value and the effects of discounting.

  12. CASE 8Fair Value Hedge of AFS Security Journal entry at 1/1/X1 Option Contract 15,000 Cash 15,000 To record payment of option premium No journal entry for hedged item

  13. CASE 8Fair Value Hedge of AFS Security Journal entries at 3/31/X1 Earnings 2,000 Investment in ABC 2,000 To record loss on investment in ABC Earnings (time value) 7,000 Option contract 5,000 Earnings (intrinsic value) 2,000 To record activity up to 3/31/X1

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