08FR-045 Cash flow hedging using an interest rate swap 30 September 2008
Contents
Cash flow hedging
Hedged risk
Assessing ...
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Cash flow hedging using an interest rate swap

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- example hedge documentation
- assessing and measuring effectiveness
- unwinding of cash flow hedge reserve to the income statement
- derivation of forward rates and discount rates from observable market information for valuing interest rate swaps.

- Worked Example

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Cash flow hedging using an interest rate swap

  1. 1. 08FR-045 Cash flow hedging using an interest rate swap 30 September 2008 Contents Cash flow hedging Hedged risk Assessing effectiveness Measuring actual ineffectiveness Valuation of interest rate swaps Appendix 1: Worked example Appendix 2: Derivation of rates This Flash Report illustrates the following for a cash flow hedge of interest rate risk: • example hedge documentation • assessing and measuring effectiveness • unwinding of cash flow hedge reserve to the income statement • derivation of forward rates and discount rates from observable market information for valuing interest rate swaps. Disclaimer: The information contained herein is of a general nature and is not intended to address the specific circumstances of any particular individual or entity. The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG, an Australian partnership, part of the KPMG International network. If you no longer wish to receive this specific email communication from KPMG, please unsubscribe. To cease receiving all email communications from KPMG in the future, please click here. © 2008 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Privacy Statement Liability limited by a scheme approved under Professional Standards Legislation. KPMG and the KPMG logo are registered trademarks of KPMG International.
  2. 2. 08FR-045 Cash flow hedging using an interest rate swap 2 © 2008 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Australia. Liability limited by a scheme approved under Professional Standards Legislation. Cash flow hedging A cash flow hedge is: • a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with a recognised asset or liability, or a highly probable forecast transaction and that could affect profit or loss • a hedging relationship where the variability of the hedged item’s cash flows is offset by the cash flows of the hedging instrument. AASB 139 Financial Instruments: Recognition and Measurement requires an entity to meet the following criteria when applying hedge accounting for cash flow hedges: • the hedge relationship is designated and documented at inception of the hedge • the hedge is expected to be highly effective at inception and throughout the life of the hedge relationship • hedge effectiveness can be reliably measured on an on-going basis • the cash flows of the hedged item are highly probable of occurring. Hedged risk The most common financial risks that an entity elect to hedge are foreign currency risk, interest rate risk and commodity price risk. This flash report focuses on interest rate risk. Interest rate risk Interest rate risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates. It arises from interest-bearing financial assets and/or liabilities (e.g. cash term deposits, issued corporate bonds and loans) or from forecast or committed future transactions with an interest-bearing element (e.g. expected debt issue, expected financing requirement, expected rollovers of existing loans). Interest-bearing financial instruments have either: • fixed interest – suitable for fair value hedge accounting as fair value changes when interest rates fluctuate. Examples include fixed rate loans and receivables, firm commitments with contractually fixed interest rates • floating interest – suitable for cash flow hedge accounting as future interest payments (cash flows) will fluctuate depending on an underlying interest index. Examples include floating rate loans and receivables and highly probable anticipated transactions where the interest rate has yet to be set. Note: An entity may choose to hedge the benchmark interest rate or the total interest rate which includes the credit margin in both fair value and cash flow hedges. Typically, an entity hedges the benchmark interest rate only to minimise the potential for any ineffectiveness. Assessing effectiveness Hedge effectiveness is the degree to which changes in the fair value or cash flows of the hedged item attributable to the hedged risk are offset by changes in the fair value or cash flows of the hedging instrument.
  3. 3. 08FR-045 Cash flow hedging using an interest rate swap 3 © 2008 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Australia. Liability limited by a scheme approved under Professional Standards Legislation. Hedge accounting can only be applied if a hedging instrument is assessed to be effective. An entity has to assess whether a hedging instrument is expected to be highly effective prospectively and whether the hedge has actually been 80-125% effective retrospectively. Prospective testing The example in Appendix 1 uses the critical terms match approach in assessing prospective effectiveness. Critical terms match approach can only be used for assessing prospective effectiveness when all the critical terms of the hedging instrument and hedged item exactly match. A hedge is considered to be highly effective if all the critical terms of the hedging instrument and hedged item exactly match (for example, notional amounts, settlement dates, underlying, credit risk and currency of cash flows) and the fair value of the hedging instrument at inception is nil. While this method does not require any calculations, it is restrictive for users as it does not allow any flexibility when terms change. For example, a change in timing of a highly probable hedged item will automatically invalidate the hedge relationship and hedge accounting will no longer apply prospectively. When the critical terms are not exactly the same, prospective effectiveness must be assessed using a quantitative approach such as, for example, a statistical model (e.g. sensitivity analysis) or dollar offset method. When timing of cash flows are not perfectly matched IFRIC considered whether an entity that designates an interest rate swap as a hedging instrument in a cash flow hedge is allowed to consider only the undiscounted changes in cash flows of the hedging instrument and the hedged item in assessing hedge effectiveness. When an interest rate swap is designated as a hedging instrument, a common reason for ineffectiveness is the mismatch of the timing of interest payments or receipts of the swap and the hedged item. Comparing only the actual cash flows on the swap with the actual cash flows on the hedged item would ignore the time value of money. An entity should therefore consider the change in value from the discounted cash flows of the hedging instrument and the hedged item when assessing hedge effectiveness. A comparison between changes in undiscounted cash flows of an interest rate swap and changes in undiscounted cash flows of the hedged item for assessing hedge effectiveness is not consistent with the requirements of the standard as it only takes into account a portion of the movements in fair value of the swap. Retrospective testing The hedge relationship must be quantitatively assessed to ensure that it has actually been highly effective throughout the past period. An entity can use different methods for assessing prospective and retrospective effectiveness. The example in Appendix 1 uses the cumulative dollar offset method for assessing retrospective effectiveness. In this example, the dollar offset method uses a hypothetical derivative to represent the future cash flows of the hedged item. A hypothetical derivative is fictitious (i.e. it does not exist). It represents the “perfect” derivative that matches the terms and conditions of the hedged item for the full term of the hedge relationship (i.e. from the inception of the hedging relationship) at each date of testing effectiveness.
  4. 4. 08FR-045 Cash flow hedging using an interest rate swap 4 © 2008 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Australia. Liability limited by a scheme approved under Professional Standards Legislation. The dollar offset method expresses the degree of offset between changes in the fair value of the hedging instrument and changes in the fair value of the hedged item as a ratio: Effectiveness = Change in fair value of hedging instrument Change in fair value of the hypothetical derivative representing the hedged item For assessing effectiveness, this test can be performed on either a cumulative basis (i.e. with comparison performed to the inception of the hedging relationship) or on a period-by-period basis (i.e. with comparison performed from the last testing date). Measuring actual ineffectiveness If a hedging instrument in a cash flow hedge is assessed to be effective, the change in fair value of the hedging instrument should be recognised in equity to the extent that it is effective. A hedge relationship that is assessed to be effective may still have some ineffectiveness, that is, it may not be 100% effective. Any ineffectiveness of the hedging instrument must be recognised in the income statement. The cumulative dollar offset method is the only measurement technique allowed for measuring actual ineffectiveness (which is the method used in the example for assessing retrospective effectiveness). In accordance with AASB 139.96, the effective portion of a cash flow hedge is the lesser of: • the cumulative gain or loss on the hedging instrument from inception of the hedge • the cumulative change in the fair value (present value) of the expected future cash flows on the hedged item from inception of the hedge. Therefore, if the cumulative gain or loss on the hedging instrument is more than the cumulative change in fair value of the expected future cash flows on the hedged item, the difference must be recognised in the income statement as ineffectiveness. However, if the cumulative gain or loss on the hedging instrument is less than the cumulative change in fair value of the hedged item, the full cumulative gain or loss on the hedging instrument is deferred in equity. In other words, ineffectiveness arising from “over-hedging” is recognised in profit or loss but ineffectiveness arising from “under-hedging” is not recognised. Valuation of interest rate swaps The valuation of an interest rate swap is illustrated in Appendix 1 and the derivation of forward interest rates and discount rates is discussed in Appendix 2. The prospective and retrospective tests require the fair values of the hedging instrument (i.e. the swap) and the hypothetical derivative to be calculated at each reporting date.
  5. 5. 08FR-045 Cash flow hedging using an interest rate swap 5 © 2008 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Australia. Liability limited by a scheme approved under Professional Standards Legislation. Appendix 1: Worked example – Cash flow hedge of a variable rate liability The following example illustrates the accounting for a cash flow hedge where the interest rate risk of a specified variable interest-bearing loan payable is hedged by an interest rate swap. It is a simple hedge relationship – the basis and the timing of the resets of both the variable leg of the swap and the loan for the entire term of the loan perfectly match. Background and assumptions • ABC Company (ABC) is an Australian company with an AUD functional currency and a 30 June year-end • ABC requires $100m to finance its operations for the next 18 months • On 1 July 2007, ABC borrows $100m in the form of a floating rate loan, repayable in 18 months. No principal repayments are made during the term of the loan. The floating rate is reset 6-monthly based on 6-monthly BBSW plus 40 basis points (0.4%), payable semi-annually in arrears • As part of ABC’s risk management policy, it determines that it does not wish to expose itself to cash flow fluctuations from changes in market interest rates. ABC elects to hedge only the benchmark interest rate component. Changes in ABC’s credit worthiness do not affect the fair value of the hypothetical derivative as the designated hedge excludes its credit risk • ABC immediately enters into an 18-month interest rate swap, with the following terms: Trade date 1 July 2007 Maturity date 31 December 2008 Notional amount AUD$100m Pay 6.767% fixed semi-annually (payable 30 June and 31 December) Receive floating cash flows based on 6-monthly BBSW • The applicable 6-monthly BBSW forward rates and discount factors as at 1 July 2007, 31 December 2007 and 30 June 2008 are shown in the table below. These rates have been derived from a zero yield curve. Reset dates 6-monthly BBSW Discount factors 1 Jul 2007 - 31 Dec 2007 31 Dec 2007 - 30 June 2008 30 June 2008 - 31 Dec 2008 1 Jul 2007 - 31 Dec 2007 31 Dec 2007 - 30 June 2008 30 June 2008 - 31 Dec 2008 1 Jul 2007 6.590% 6.843% 6.878% 0.9678 0.9359 0.9045 31 Dec 2007 7.360% 7.570% 0.9646 0.9291 30 Jun 2008 7.963% 0.9614 See Appendix 2 for further explanation on par and yield curves, and the derivation of forward rates and discount factors from yield curves.
  6. 6. 08FR-045 Cash flow hedging using an interest rate swap 6 © 2008 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Australia. Liability limited by a scheme approved under Professional Standards Legislation. Hedge documentation ABC’s hedge documentation for the hedge transaction is as follows: Date of designation 1 July 2007 Type of hedge Cash flow hedge Risk management objective On 1 July 2007, ABC borrows AUD$100m on a floating rate (BBSW) loan which is repayable in 18 months. Interest is repriced 6-monthly based on 6-monthly (BBSW), payable in arrears. As a result, ABC is exposed to changes in the benchmark interest rate (BBSW) To reduce this exposure, ABC enters into an 18-month interest rate swap (IRS) on 1 July 2007 to hedge its AUD$100m floating rate borrowing. The objective of the hedge is to fix the interest rate on the loan that is related to the BBSW- indexed component to 6.767%. The combination of the interest rate swap and the 40bp credit spread will result in an expected interest outflow equivalent to 7.167%. This hedging objective is consistent with ABC’s overall risk management strategy. Nature of hedged risk Interest rate risk – the variability in cash flows on the floating rate loan attributable to changes in 6-monthly BBSW. Hedged item The variability to 6-monthly BBSW in the AUD$100m floating rate loan borrowed on 1 July 2007 from Bank which will mature on 31 December 2008. Only exposure to 6-monthly BBSW has been designated as the hedged risk. The credit spread in the borrowing is excluded. Hedging instrument The hedging instrument is an IRS with the following terms: Counterparty Counterparty XYZ Notional Amount AUD 100,000,000 Deal ref # 100 Pay 6.767% semi-annually Trade date 1 July 2007 Receive Six-monthly BBSW Maturity date 31 December 2008 Assessing hedge effectiveness Prospective effectiveness will be tested at the inception of the hedge and at each reporting date by comparing the critical terms of the hedging instrument and the hedged item. Retrospective effectiveness will be tested at each reporting date using the cumulative dollar offset method. Hedge effectiveness will be assessed and measured on a cumulative basis by calculating the change in the fair value of the IRS as a percentage of the change in the fair value of the designated hedged item (measured using the hypothetical derivative). The hypothetical derivative that represents the hedged future cash flows is an interest rate swap entered into on 1 July 2007 to pay fixed 6.767% semi-annually and receive 6-monthly BBSW. If the ratio of the change in fair value is within the 80-125% range, the hedge is considered to be effective.
  7. 7. 08FR-045 Cash flow hedging using an interest rate swap 7 © 2008 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Australia. Liability limited by a scheme approved under Professional Standards Legislation. Effectiveness tests and accounting entries 1 July 2007 – obtain credit facility; enter into interest rate swap (IRS) Need to: 1 test prospective effectiveness 2 determine accounting entries required. 1 Prospective effectiveness test As set out in its hedge documentation, prospective effectiveness will be tested at inception of the hedge by comparing the critical terms of the hedging instrument and hedged item. Hedging instrument Hedged item Notional amount AUD$100m AUD$100m Payments 6-monthly BBSW Receive 6-monthly BBSW Pay 6.767% fixed Pay (semi annually) 0.4% margin (not part of hedge) Payment dates 31 Dec 07, 30 June 08, 31 Dec 08 31 Dec 07, 30 June 08, 31 Dec 08 Maturity 31 December 2008 31 December 2008 Interest reset dates 1 July 07, 31 Dec 07, 30 June 08 1 July 07, 31 Dec 07, 30 June 08 As the critical terms of the hedging instrument and hedged item match, the hedging relationship is considered to be highly effective. 2 Accounting entries on 1 July 2007 1 Record proceeds from the loan Dr Cash (B/S) 100,000,000 Cr Credit facility payable (B/S) 100,000,000 To record the proceeds from the loan No accounting entries are required for the IRS as the fair value of the IRS at inception is nil. Refer to the following table for initial fair value calculations.
  8. 8. 08FR-045 Cash flow hedging using an interest rate swap 8 © 2008 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Australia. Liability limited by a scheme approved under Professional Standards Legislation. 1 July 2007 Total Cashflow in/(outflow) 31-Dec-07 30-Jun-08 31-Dec-08 Notional 100,000,000 Fixed leg (pay) Fixed interest rate 6.767% 6.767% 6.767% Cash flows (Note 1) (3,411,309) (3,374,230) (3,411,309) Discount factor (Note 2) 0.9678 0.9359 0.9045 Discounted fixed interest (3,301,464) (3,157,941) (3,085,529) (9,544,934) Floating leg (receive) 6-mth BBSW forward rate (Note 3) 6.590% 6.843% 6.878% Cash flows 3,322,081 3,412,126 3,467,265 Discount factor (Note 2) 0.9678 0.9359 0.9045 Discounted forecast variable interest 3,215,110 3,193,408 3,136,141 9,544,659 Fair value of net interest at inception (86,354) 35,467 50,612 0 * 31-Dec-07 30-Jun-08 31-Dec-08 Notional 100,000,000 Fixed leg (receive) Fixed interest rate 6.767% 6.767% 6.767% Cash flows (Note 1) 3,411,309 3,374,230 3,411,309 Discount factor (Note 2) 0.9678 0.9359 0.9045 Discounted fixed interest 3,301,464 3,157,941 3,085,529 9,544,934 Floating leg (pay) 6-mth BBSW forward rate (Note 3) 6.590% 6.843% 6.878% Cash flows (3,322,081) (3,412,126) (3,467,265) Discount factor (Note 2) 0.9678 0.9359 0.9045 Discounted forecast variable interest (3,215,110) (3,193,408) (3,136,141) (9,544,659) Fair value of hypothetical at inception 86,354 (35,467) (50,612) 0 * Total Cashflow in/(outflow) Current fair value Fair value of hedging instrument (IRS) Current fair value Fair value of hedged item (Hypothetical derivative) Notes 1 Differences in cash flows are due to the assumption that there are 182 days from 1 Jan to 30 June and 184 days from 1 July to 31 December (e.g. for June 2008, 182/365 x 100m x 6.767% = 3,374,230). 2 Discount factor from yield curve derived from AA Interbank swap curve as at 1 July 2007. 3 Forward rates from yield curve derived from AA Interbank swap curve as at 1 July 2007. * Fair value on day 1 is nil. However for the purposes of this example a calculated balance of $275 arises as a result of rounding.
  9. 9. 08FR-045 Cash flow hedging using an interest rate swap 9 © 2008 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Australia. Liability limited by a scheme approved under Professional Standards Legislation. 31 December 2007 – reporting date; payment of interest on credit facility; settlement of interest on IRS Need to: 1 test retrospective effectiveness 2 determine accounting entries required 3 test prospective effectiveness.
  10. 10. 08FR-045 Cash flow hedging using an interest rate swap 10 © 2008 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Australia. Liability limited by a scheme approved under Professional Standards Legislation. 1 Retrospective effectiveness test 31 December 2007 Retrospective effectiveness test 30-Jun-08 31-Dec-08 Notional 100,000,000 Fixed leg (pay) Fixed interest rate 6.767% 6.767% Cash flows (Note 1) (3,374,230) (3,411,309) Discount factor (Note 2) 0.9646 0.9291 Discounted fixed interest (3,254,782) (3,169,447) (6,424,229) Floating leg (receive) 6-mth BBSW forward rate (Note 3) 7.360% 7.570% Cash flows 3,669,918 3,816,109 Discount factor (Note 2) 0.9646 0.9291 Discounted forecast variable interest 3,540,003 3,545,546 7,085,549 Current fair value of IRS 285,221 376,099 661,320 Cumulative change in fair value of IRS A 661,320 Cashflow in/(outflow) 30-Jun-08 31-Dec-08 Notional 100,000,000 Fixed leg (receive) Fixed interest rate 6.767% 6.767% Cash flows (Note 1) 3,374,230 3,411,309 Discount factor (Note 2) 0.9646 0.9291 Discounted fixed interest 3,254,782 3,169,447 6,424,229 Floating leg (pay) 6-mth BBSW forward rate (Note 3) 7.360% 7.570% Cash flows (3,669,918) (3,816,109) Discount factor (Note 2) 0.9646 0.9291 Discounted forecast variable interest (3,540,003) (3,545,546) (7,085,549) Current fair value of hypothetical (285,221) (376,099) (661,320) Cumulative change in fair value of hypothetical derivative B (661,320) Effectiveness (100.00%)Cumulative change in FV of hedging instrument (A) Current fair value Current fair value Fair value of hedged item (hypothetival derivative) Total Cashflow in/(outflow) Cumulative change in FV of hedged item (B) Fair value of hedging instrument (IRS) Current valuation of cash flows Notes 1 Differences in cash flows are due to the fact that there are 182 days from 1 Jan to 30 June and 184 days from 1 July to 31 December. 2 Discount factor from yield curve derived from AA Interbank swap curve as at 31 December 2007. 3 Forward rates from yield curve derived from AA Interbank swap curve as at 31 December 2007.
  11. 11. 08FR-045 Cash flow hedging using an interest rate swap 11 © 2008 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Australia. Liability limited by a scheme approved under Professional Standards Legislation. 2 Accounting entries on 31 December 2007 1 Record six months interest expense on the loan payable Dr Interest expense (P&L) 3,523,726 Cr Cash (B/S) 3,523,726 To record the payment of 6.990% floating interest on the credit facility: 6-monthly BBSW 6.590% set on 1 July 2007 plus premium of 0.4% (100m x 6.99% x 184/365) 2 Net settlement of interest on IRS for the six-month period to 31 December 2007 Dr Interest expense (P&L) 89,228 Cr Cash (B/S) 89,228 To record the net settlement of the IRS for the period 1 July 2007 to 31 December 2007: pay 6.767% fixed; receive 6.59% floating 6-monthly BBSW. ($3,411,309,-$3,322,081) The interest rate on the receive leg is determined at the beginning of the 6-monthly interest period as interest is paid in arrears under the swap. 3 Fair value adjustment Dr Fair value derivative (B/S) 661,320 Cr Cash flow hedging reserve (B/S) 661,320 To record the effective change in fair value of the derivative. Releasing the hedging reserve to the income statement The net impact of the above journals should reconcile as follows: • the balance in the hedging reserve of $(661,320), represents the fair value of the remaining future forecast interest cash flows. AASB 139.100 only allows amounts to be transferred to the income statement when the forecast transaction affects the income statement • the interest expense recognised in the income statement should be based upon the fixed interest rate plus the margin, i.e. 6.767% + 0.4% = 7.167%. (i.e. 100m x 7.167% x 184/365). 3 Prospective effectiveness test AASB 139.88 requires the prospective effectiveness test to be performed to ensure the hedging relationship is expected to remain effective going forward. As there has been no changes to the critical terms of the hedging instrument or the hedged item, the hedge is considered to be highly effective.
  12. 12. 08FR-045 Cash flow hedging using an interest rate swap 12 © 2008 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Australia. Liability limited by a scheme approved under Professional Standards Legislation. 30 June 2008 – reporting date; payment of interest on credit facility; settlement of interest on IRS Need to: 1 test retrospective effectiveness 2 determine accounting entries required 3 test prospective effectiveness.
  13. 13. 08FR-045 Cash flow hedging using an interest rate swap 13 © 2008 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Australia. Liability limited by a scheme approved under Professional Standards Legislation. 1 Retrospective effectiveness test 30 June 2008 Retrospective effectiveness test 31-Dec-08 Total Cashflow in/(outflow) Notional 100,000,000 Fixed leg (pay) Fixed interest rate 6.767% Cash flows (Note 1) (3,411,309) Discount factor (Note 2) 0.9614 Discounted fixed interest (3,279,632) (3,279,632) Floating leg (receive) 6-mth BBSW forward rate (Note 3) 7.963% Cash flows 4,014,224 Discount factor (Note 2) 0.9614 Discounted forecast variable interest 3,859,275 3,859,275 Current fair value of IRS 579,643 579,643 Fair value of IRS at inception 0 Cumulative change in fair value of IRS A 579,643 Cashflow in/(outflow) 31-Dec-08 Notional 100,000,000 Fixed leg (receive) Fixed interest rate 6.767% Cash flows (Note 1) 3,411,309 Discount factor (Note 2) 0.9614 Discounted fixed interest 3,279,632 3,279,632 Floating leg (pay) 6-mth BBSW forward rate (Note 3) 7.963% Cash flows (4,014,224) Discount factor (Note 2) 0.9614 Discounted forecast variable interest (3,859,275) (3,859,275) Current fair value of hypothetical (579,643) (579,643) Fair value of hypothetical at inception 0 Cumulative change in fair value of hypothetical derivative B (579,643) Effectiveness (100.00%) Fair value of hedging instrument (IRS) Current fair value Fair value of hedged item (hypothetival derivative) Current valuation of cash flows Current fair value Cumulative change in FV of hedging instrument (A) Cumulative change in FV of hedged item (B) Notes 1 Cash flows calculated based on 184 days from 1 July to 31 December. 2 Discount factor from yield curve derived form AA Interbank swap curve as at 30 June 2008. 3 Forward rates from yield curve derived from AA Interbank swap curve as at 30 June 2008.
  14. 14. 08FR-045 Cash flow hedging using an interest rate swap 14 © 2008 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Australia. Liability limited by a scheme approved under Professional Standards Legislation. 2 Accounting entries on 30 June 2008 1 Record six months interest expense on the loan payable Dr Interest expense (P&L) 3,869,370 Cr Cash (B/S) 3,869,370 To record the payment of 7.760% floating interest on the loan payable: 6-monthly BBSW set on 31 December 2007 7.360% plus premium of 0.4%. (100m x 7.76% x 182/365) 2 Net settlement of interest on IRS for the six-month period to 30 June 2008 Dr Cash (B/S) 295,668 Cr Interest expense (P&L) 295,668 To record the net settlement of the IRS for the period 1 January 2008 to 30 June 2008: pay 6.767% fixed; receive 7.360% floating 6-monthly BBSW. ($3,374,230-$3,669,918) 3 Fair value adjustment Dr Cash flow hedging reserve (B/S) 81,677 Cr Fair value derivative (B/S) 81,677 To record the effective change in fair value of the derivative. Movement from $661,320 (31 December 2007) to $579,643 (30 June 2008) 3 Prospective effectiveness test As there has been no changes to the critical terms of the hedging instrument or the hedged item, the hedge is considered to be highly effective.
  15. 15. 08FR-045 Cash flow hedging using an interest rate swap 15 © 2008 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Australia. Liability limited by a scheme approved under Professional Standards Legislation. 31 December 2008 – reporting date; settlement of loan payable and IRS Need to: 1 Determine accounting entries required 1 Accounting entries on 31 December 2008 1 Record six months interest expense on the credit facility Dr Interest expense (P&L) 4,215,868 Cr Cash (B/S) 4,215,868 To record the payment of 8.363% floating interest on the credit facility: 6-monthly BBSW 7.963% set on 30 June 2008 plus premium of 0.4% ($100m x 8.363% x 184/365) 2 Net settlement of interest on IRS for the six-month period to 31 December 2008 Dr Cash (B/S) 602,915 Cr Interest expense (P&L) 602,915 To record the net settlement of the IRS for the period 1 July 2008 to 31 December 2008: pay 6.767% fixed; receive 7.963% floating 6-monthly BBSW. ($3,411,309-$4,014,224) 3 Fair value adjustment Dr Cash flow hedging reserve (B/S) 579,643 Cr Fair value derivative (B/S) 579,643 To record the effective change in fair value of the derivative. Movement from $579,643 (30 June 2008) to nil (31 December 2008) 4 Settlement of loan payable Dr Loan Statement 100,000,000 Cr Cash (B/S) 100,000,000 To record the settlement of the loan
  16. 16. 08FR-045 Cash flow hedging using an interest rate swap 16 © 2008 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Australia. Liability limited by a scheme approved under Professional Standards Legislation. Appendix 2: Derivation of forward rates and discount rates Zero coupon yield curves and par curves The zero coupon yield curve (yield curve) is a line that plots zero coupon interest rates of zero coupon bonds, at a point in time, that have equal credit quality, but differing maturity dates. Zero coupon bonds are bonds where interest and principal are repayable only at maturity. The yield to maturity of a zero coupon bond is used as a benchmark for other bond yields and valuation because there is no reinvestment risk in a zero coupon bond (given that it has no coupon payments) and, therefore, the precise yield to maturity of the bond is known. The yield curve is typically derived from a market par curve for coupon bearing instruments. The par curve reflects current yields to maturity for applicable coupon bearing reference bonds that are traded in the marketplace. An example of a common par curve that is observable is the AA interbank swap curve. Zero coupon rates are derived from the market yields on the par curve by eliminating the effect of coupon payments through a process known as “boot strapping”. What are zero coupon yield curves used for? The yield curve is used to calculate: • forward interest rates. The forward interest rate is a one-period interest rate beginning and maturing in a forward period. An example is the 6-monthly interest rate for a financial instrument beginning in six months time and maturing in 12-months These forward rates are used to estimate the future variable cash flows of the floating leg of an interest rate swap. • a discount factor. The discount factor is used to discount future cash flows (such as principal and interest) to arrive at their fair value.
  17. 17. 08FR-045 Cash flow hedging using an interest rate swap 17 © 2008 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Australia. Liability limited by a scheme approved under Professional Standards Legislation. How does it apply to our worked example? The AA Interbank swap curves as at 30 June 2007, 31 December 2007 and 30 June 2008 are as follows: Par curves - AA Interbank Swap Curves 6.0% 6.3% 6.5% 6.8% 7.0% 7.3% 7.5% 7.8% 8.0% 8.3% - 12 24 36 48 60 Maturity (months) Rate 30 June 2008 31 Dec 2007 30 June 2007 From the above par curves, the following yield curves as at 30 June 2007, 31 December 2007 and 30 June 2008 were derived: Zero yield curves 6.0% 6.3% 6.5% 6.8% 7.0% 7.3% 7.5% 7.8% 8.0% 8.3% 8.5% 8.8% 9.0% 9.3% 9.5% - 12 24 36 48 60 Maturity (months) Rate 30 June 2008 31 Dec 2007 30 June 2007

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