Question

Exercise A-4 (Algo) Derivatives; interest rate swap; fixed rate debt; fair value change unrelated to hedged risk [LOA–2] LLB Industries borrowed $330,000 from Trust Bank by issuing a two-year, 12% note, with interest payable quarterly. LLB entered into a two-year interest rate swap agreement on January 1, 2021, and designated the swap as a fair value hedge. Its intent was to hedge the risk that general interest rates will decline, causing the fair value of its debt to increase. The agreement called for the company to receive payment based on a 12% fixed interest rate on a notional amount of $330,000 and to pay interest based on a floating interest rate. Floating (LIBOR) settlement rates were 12% at January 1, 10% at March 31, and 8% at June 30, 2021. The fair values of the swap are quotes obtained from a derivatives dealer. Those quotes and the fair values of the note are as indicated below. The additional rise in the fair value of the note (higher than that of the swap) on June 30 was due to investors’ perceptions that the creditworthiness of LLB was improving. January 1 March 31 June 30 Fair value of interest rate swap 0 $ 7,772 $ 13,994 Fair value of note payable $ 330,000 $ 337,772 $ 350,000 Required: 1. Calculate the net cash settlement at June 30, 2021. 2. Prepare the journal entries on June 30, 2021, to record the interest and necessary adjustments for changes in fair value.

Answer 1

Answer 1

==>June 30, 2021

Fair value of interest rate swap ==>$13,994

Fair value of note payable ==>$350,000

Fixed rate payable quaterly==> 12%/4 ==>3%

Floating Rate ==>8%/4 ==>2%

Fixed interest receipts ==>$330,000 x 3% ==>$9,900

Less Floating payments ==>$330,000 x 2% ==>$6,600

Net cash settlement==>$3,300

-----------