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Working Paper 284 FloorIT Bank Options Case: Hedging Strategies and Accounting Under SFAS 133/IAS 39 for Eurodollar Interest Rate Options to Floor Lending Rates on Forecasted Loan Transactions Bob Jensen at Trinity University Case Objectives The broad objectives of this FloorIT Bank case and its companion case called CapIT Corporation are as follows: To help students learn the rather complicated ways in which premium quotations on the Eurodollar options trading markets, as reported in the financial press, can be translated into alternatives to hedge variable interest rates. Examples found in finance textbooks and in the accounting standards pronouncements usually skip over this complex step in evaluating hedging strategies and accounting outcomes. To help students learn how to use Eurodollar interest rate options to cap or floor borrowing and lending rates. One question in each case asks students to evaluate the advantages and disadvantages of options relative to other hedging alternatives such as interest rate swaps and forward/futures contracts. To help students learn how to distinguish the interest rate caps and floors before and after premium costs are factored into “effective” net rate calculations. Option premium rates listed daily on the Chicago Mercantile Exchange (CME) are factored into effective rate calculations. To help students learn the complicated mechanics of accounting for Eurodollar interest rate hedges under SFAS 133 and IAS 39 rules. SFAS 133 is entitled Accounting for Financial Instruments and Hedging Activities (Norwalk, CT: Financial Accounting Standards Board (FASB), Product Code No. S133, 1998). Because SFAS 133 is so complex and confusing to corporate and public accountants, its implementation was postponed in June 1999 for another year. In 1999, the International Accounting Standards Committee (IASC) issued a similar international standard called IAS 39. To help students learn the complicated mechanics of calculating intrinsic values and time values of option premiums quoted as annual percentage rates that must be translated into dollar values for loans having terms different than one year. Such calculations are important, because they impact upon how SFAS 133 requires reporting of derivative instruments current values. Some important points of difference between SFAS 133 in the U.S. and IAS 39 internationally are stressed in this case. . Case Introduction Note that all terminology definitions are given at http://WWW.Trinity.edu/rjensen/acct5341/speakers/133glosf.htm#0000Begin On June 17, 1999 FloorIT Bank had a forecasted transaction to lend $25 million in three months at a variable rate. The CFO of FloorIT, Pete Boniff, commenced to worry about falling rates following the cessation of NATO bombing in Kosovo. Signs pointed to rising prices that might lead to upward movements in lending costs worldwide. By September 17 when the intended loan would take place, interest rates might be very low. The London Interbank Offering Rate (LIBOR) stood at 5.18% on June 17. By September 17, it might well fall to 4% or lower as world governments seek to stimulate their economies. The FloorIT Bank forecasted transaction entailed lending $25 million at a negotiated rate of LIBOR+0.45% APR. This rate reduces to (LIBOR+0.45%)(3/12 yr) for the intended loan period from September 17 to December 17. FloorIT Page 2 The cost of an option in a trading market such as the CME is called the “premium.” The “underlying” of an interest rate option is usually some type of note having a principal amount referred to as the “notional.” Call give holders the option to purchase notes at contracted strike rates that translate into strike prices for notes. Put options give holders the option to sell notes at contracted strike rates that translate into strike prices for notes. Always remember that as interest rates go up, note prices fall in trading markets and vice versa. As a result, call options are “in-the-money” if spot (current) interest rates fall below strike rates. Put options are “inthe-money” if spot rates rise above strike rates. The difference between a spot rate value and an option’s strike value (after translating strike rates into dollar values) is called the option’s “intrinsic value.” Options may be valuable even if their intrinsic values are negative. The reason is the time value component equal to the difference between total value and intrinsic value. Time value tends to decrease as options approach expiration dates. The farther away the expiration date, the more time the option has to eventually attain positive intrinsic value. American-style options can be exercised whenever they are in-the-money, whereas European-style options cannot be exercised until the expiration date. Asian-style options compute the payoff based upon an average intrinsic value over time. Option holders do not incur a penalty if options are never exercised. The maximum loss is the premium paid up front. Option writers sell the options and receive the premiums, but they take on much greater risk than option holders. For example, if interest rates soar, the put option writer’s liability is unbounded in the sense that the option writer must settle the contracts at spot rates. If interest rates plunge, the put option writer’s gain is limited to the premium received. The put option holder’s potential for gain is unbounded, whereas the loss is always equal to the premium paid for the option. Holders of call options gain from plunging spot rates, whereas holders of put options gain from soaring interest rates. Interest rate options are traded on in organized markets such as the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT). In some instances the option settlements require physical delivery of U.S. Treasury bills, U.S. Treasury notes or some other contracted delivery items such as municipal bonds. For example, if a call option for U.S. Treasury notes is in-the-money, the call option holder might “call” for contracted delivery (from the option writer) of notes having a smaller strike prices (due to a higher strike interest rates under the option contract) than the higher spot prices caused by drops in interest rates in the current market The option holder may then sell the “called” notes at the higher spot prices for a profit. Many investors purchase interest rate calls in pure speculation that interest rates are going to go down (thereby creating call option gains from a rising note prices in the open market). But instead of speculating. money lenders may hedge against falling interest rates by purchasing interest rate call options to offset possible declines in lending rates. It is possible to set a minimum floor on net revenue such that when lending interest rates drop below the floor interest rates, the gains from the “called” options exactly offset losses from having to lend below floor rates. Call options make a nice hedge for money lenders such as FloorIT Bank, because there is no risk due to uncertain future movements in interest rates. Call options need not be exercised if strike interest rates are lower than spot rates (such that note “call” purchase prices are above spot market selling prices). The maximum loss is the price (premium) of each option that is paid up front when option is purchased. Unlike forward contract or futures contract hedges, there is no risk of further losses in either a speculation or a hedge no matter what happens to future interest rates. Eurodollar notes should not be confused with the new Euro currency. Eurodollar notes are virtually risk free obligations of U.S. Banks that carry contracted interest rates. Eurodollars are time deposits in commercial banks outside the United States. Most are in Europe, but they are not confined to Europe. The Chicago Mercantile Exchange (CME) offers Eurodollar time deposit futures contracts and American style interest rate options that can be exercised at any time during the contract period. All CME options prices (premiums) move in discrete "ticks" of 0.01 depicting 0.01% of the notional amount. For a $1 million notional, the annualized tick is equivalent, therefore, to $100 = ($1,000,000)(0.01%) = $10,000. The 0.01%, however, is an annual percentage rate (APR). The Eurodollar notes on the CME are 90-day notes, such that options premiums are based upon the three-month portions of 0.01%. For example, a call option having a listed premium of 1.45 will have a cost of $3,625 = (1.45%)($1,000,000)(3/12 yr). A somewhat more convenient way of calculating the premium is X = $2,500P where P is the quoted premium. For example, when P=1.45, the dollar cost of the Eurodollar interest rate option is $3,625 = ($2,500)(1.45). Different interest rate options such FloorIT Page 3 as a 13-week U.S. Treasury bill would base the calculation on 13 weeks rather than the three-month time span of a Eurodollar option. Eurodollar interest-rate options are somewhat different in that they can be settled net for cash and need not require physical delivery notes themselves. These are traded in the International Money Market (IMM) of the CME. This FloorIT Bank case focuses on the purchase of call options in the IMM. Call options are used by FloorIT to hedge a forecasted transaction to borrow $25 million. Pete Boniff decided on a call option having a strike price of 9,450 basis points which is equivalent to a strike rate of 5.50%. The call option is a "long position" on a futures contract to acquire Eurodollars at any time between June 17 and September 17 at the strike price. If interest rates plunge below the strike rate, the call option has positive intrinsic value that can be settled at any time (as an American-style option) for cash. If interest rates fall, the price of Eurodollars declines. In theory, FloorIT could call (buy) "cheap" Eurodollars at high contracted strike interest rates and later sell them for soaring prices due to plunging spot interest rates. What really happens, however, is that there is no physical moving of Eurodollars. The intrinsic value of the excess of the spot interest rate over the contracted strike rate is settled in cash whenever FloorIT elects to exercise the call option. On June 17, Pete Boniff purchased 25 September Eurodollar interest-options in order to place a floor on the September 17 lending rate. This hedge cost $90,625 using the quoted premiums on the Chicago Mercantile Exchange (CME) given in the Wall Street Journal. These premiums are reproduced in Exhibit 1 of this case. In the case of a call option, the option holder may acquire (buy) the note at a strike price based upon the corresponding strike rate of interest. Strike is the term since a deal has been “struck” according to terms of the contract. In the case of a call option, the holder may deliver (sell) the note at the strike price corresponding to the strike rate of interest. _____________________________________________________________________________________ Insert Exhibit 1 About Here _____________________________________________________________________________________ FloorIT Page 4 Case Questions (in black) With Answers (in red) (Students fill in the answers shown here in red.) 1. Exhibit 1 contains two types of options. Assume that call options are used on June 17 to floor the revenue on $25 million FloorIT Bank intends to lend on September 17. Assume the note rate is the September 17 spot LIBOR plus 0.45%. In other words, fill in the following table using Exhibit 1 and explain your calculations: Strike Price Expressed Interest Rate Floor Cost of 25 Contracts Interest Rate Floor as an APR % Excluding Premium (Aggregated Premium) Including Premium 5.75% APR 5.75%+0.45%=6.20% $206,250 02.90% APR 5.50% APR 5.50%+0.45%=5.95% $ 90,625 04.50% APR 5.25% APR 5.25%+0.45%=5.70% $ 25,000 05.30% APR 5.00% APR 5.00%+0.45%=5.45% $ 6,250 05.35% APR Assume that 25 options (contracts that each have a $1 million notional) are purchased on June 17 in order to hedge the lending rate for the $25 million loan. Note that even though the Exhibit 1 strike prices pertain to intervals shorter than one year, they equate to an annual percentage rate (APR). For example, a strike price of 9,425 basis points is equivalent to an APR of (10,000-9,425)/100 = 5.75% APR. For a September call premium P, the scaling factor is $2,500P in Exhibit 1. For example, a call option having a strike price of 9,425 basis points costs $2,500P = ($2,500)(3.30) = $8,250 per contract. The premium for a strike price of 9,450 basis points costs $2,500P = ($2,500)(1.45) = $3,625 per contract. Each contract has a $1,000,000 notional. The floor rate is equal to 0.45% plus the strike price rate adjusted for the cost (premium) of the option expressed as a percentage of the loan value. For example, the calculation is shown for you in the case of two strike prices in Exhibit 1. The 9,425-strike price is equivalent to (10,0009,425)/100 = 5.75%. The lending rate at this strike price is (5.75%+0.45%) = 6.20%. The floor rate of a call option for the 9,425-strike price is (5.75% strike + 0.45% + 0.25% premium) = 6.45%. In your solutions, please express all rates in annualized APR terms until you actually compute the cash flows for three-month contracts. Each contract has a $1,000,000 notional. Show all calculations that you place in the cells of the above answer table. [(3.30)($2500)(25 call contracts)] = [(1.45)($2500)(25 call contracts)] = [(0.40)($2500)(25 call contracts)] = [(0.10)($2500)(25 call contracts)] = $206,250 $ 90,625 $ 25,000 $ 6,250 for a strike rate of (10,000 – 9,425)/100 = 5.75% APR for a strike rate of (10,000 – 9,450)/100 = 5.50% APR for a strike rate of (10,000 – 9,475)/100 = 5.25% APR for a strike rate of (10,000 – 9,500)/100 = 5.00% APR It may be more revealing in terms of each option's $1,000,000 notional to compute the contract costs as follows: [(0.25%)($1,000,000)(3/12 yr)(25 call contracts)] = [(1.45%)($1,000,000)(3/12 yr)(25 call contracts)] = [(2.30%)($1,000,000)(3/12 yr)(25 call contracts)] = [(4.45%)($1,000,000)(3/12 yr)(25 call contracts)] = [(6.90%)($1,000,000)(3/12 yr)(25 call contracts)] = [(9.40%)($1,000,000)(3/12 yr)(25 call contracts)] = The effective floor rates are computed below: $ 15,625 $ 53,125 $143,750 $278,125 $431,250 $587,500 for a strike rate = for a strike rate = for a strike rate = for a strike rate = for a strike rate = for a strike rate = 5.75% APR 5.50% APR 5.25% APR 5.00% APR 4.75% APR 4.50% APR = 9,425-strike = 9,450-strike = 9,475-strike = 9,500-strike = 9,525-strike = 9,550-strike FloorIT Page 5 9,425 call strike price floor rate = 5.75% +0.45% - 3.30% premium 9,450 call strike price floor rate = 5.50% +0.45% - 1.45% premium 9,475 call strike price floor rate = 5.25% +0.45% - 0.40% premium 9,500 call strike price floor rate = 5.00% +0.45% - 0.10% premium = = = = 2.90% APR 4.50% APR 5.30% APR 5.35% APR effective rate effective rate effective rate effective rate Explain the derivation of the “$2,500 scaling factor.” In order to explain its derivation, think of the Exhibit 1 option premiums as annual percentage rates on $1,000,000 notional amounts. For example, a 1.45% APR call option premium for a September settlement translates to a dollar amount of (1.45%)($1,000,000) = $14,500 per year. However, the time period between June 17 and September 17 is only three months, reducing the premium cost to ($14,500)(3/12 yr) = $3,625 per call option contract. Hence, 25 contracts cost FloorIT Bank ($3,625)(25) = $90,625. This is explained as follows in the case itself. Each CME option contract’s price (premium) moves in discrete "ticks" of 0.01 depicting 0.01% of the notional amount. For a $1 million notional, the tick is equivalent, therefore, to $100 = ($1,000,000)(0.01%). The 0.01%, however, is an annual percentage rate (APR). The Eurodollar notes on the CME are 90-day notes, such that options premiums are based upon the three-month portions of 0.01%. For example, a call option having a listed premium of 1.45 will have a cost of $3,625 = (1.45%)($1,000,000)(3/12 yr). A somewhat more convenient way of calculating the premium is X = $2,500P where P is the quoted premium. For example, when P=1.45, the dollar cost of the Eurodollar interest rate option is $3,625 = ($2,500)(1.45). Different interest rate options such as a 13-week U.S. Treasury bill would base the calculation on 13 weeks rather than the three-month time span of a Eurodollar option. 2. What are the scaling factors for July, August, and September call option having a premiums of J, A, and S respectively in Exhibit 1? For example, for a 9,450-strike price July call option, we find J = 1.00 = (1.000%)(100) in Exhibit 1. For a 9,450-strike price August option, we find A = 1.25 = (1.25)(100). For a 9,500-strike price September option, we find S = 0.10 = (0.10%)(100) in Exhibit 1. What are the corresponding scaling factors used to compute the call option costs as a function of J, A, or S values given in Exhibit 1? The scaling factor is always the $2,500 = (.01)($1,000,000)(3/12 yr) even if the July options purchased on June 17 expire in (1/12) of a year and the August options expire in (2/12) of a year. The amount of time remaining until expiration does not affect the scaling factor used in converting quoted Eurodollar option premiums into dollar premiums. Let P depict a July (J), August (A), or September (S) price in Exhibit 1. The amount to be paid for the option is X=$2,500P in every case. When J=1.00 in Exhibit 1, the cost of the one-month option is $2,500=($2,500)(1.00). When A=1.25, the cost of the two-month option is $3,125=($2,500)(1.25). When S=0.10, the cost of the three-month option is $250=($2,500)(0.10). What determines the scaling factor is the contracted time period of the underlying note. Eurodollar notes on the CME all have a three-month contracted time period. Hence, the scaling factor is based upon (3/12) of a year no matter whether the option expires in July, August, or September in Exhibit 1 3. Suppose that on June 17, FloorIT Bank elects to floor the $25 million forecasted variable rate lending planned for September 17. Assume Pete Boniff decides to place a floor on the variable rate by purchasing 25 September call options having a strike price of 9,450 in Exhibit 1. If LIBOR falls to a 4.00% APR on September 17, compute the September 17 cash settlement (positive or negative) for FloorIT interest rate hedge of a lending of $25 million from September 17 to December 17 (when the loan is paid off). What is the three-month interest cost in total dollars if the variable loan rate is specified at the September 17 LIBOR plus 0.45%? What is the net cost after these interest cash outflows are adjusted for the net profit of the call option hedge? Hint: Multiply all interest calculations by (3/12) or divide by 4 for cash flow calculations for three-month FloorIT Page 6 intervals. September 17 settlement at LIBOR=4.20% becomes (5.50%-4.00%)($25m)(3/12 yr) Less the June 17 cost (premium) for 25 hedging option contracts = -(1.45)($2,500)(25) Net income on the 25 hedging option contracts having a 9,450-strike price = $93,750 = - 90,625 = $ 3,125 Alternately, this can be computed with the tick rate’s annualized $10,000 scaling factor as follows: September 17 settlement at LIBOR=4.20% becomes (5.50%-4.00%)($25m)(3/12 yr) Less the June 17 cost (premium) for 25 contracts = -(1.45%)($10,000)(25) (3/12 yr) Net income on the 25 hedging option contracts having a 9,450-strike price = $93,750 = - 90,625 = $ 3,125 Net interest on $25 million from September 17 to December 17 at 4.00% spot rate+0.45% = $278,125 Net revenue of hedged loan = $278,125 revenue + $3,125 hedge Proof calculation = ($25,000,000)(4.50% floor rate)(0.25 yr) = $281,250 for three months = $281,250 for three months What is the net lending rate APR after the settlement of the 25 call hedging contracts are factored into the calculation based upon a September 17 LIBOR of 4.00%? [($281,250/$25,000,000)(12/3 quarters) = 4.50% which is equal to the hedged floor rate of 4.50%. 4. What portions of the call option’s 1.45% premium rate for June 17 in Exhibit 1 are intrinsic value rates versus time value rates? Recall that on June 17, the spot LIBOR was 5.18%. FloorIT Bank chose the 5.50% strike rate corresponding to 9,450 basis points. Hint: Intrinsic value is discussed in Bob Jensen’s SFAS 133 and IAS 39 Glossary. An illustration of intrinsic value versus time value accounting is given in Example 9 of SFAS 133, Pages 84-86, Paragraphs 162-164. [(5.50% strike – 5.18 LIBOR)] [1.45% total - (+0.32% intrinsic)] = +0.32% intrinsic value portion of 1.45% June 17 premium = +1.13% positive time value portion of 1.45% June 17 premium What portions of the total cost (in dollars) of 25 call option contracts on June 17 are intrinsic value dollars versus time value dollars? Recall that each option has a $1,000,000 notional in Exhibit 1. [(+0.32 intrinsic value rate)($2500)(25 contracts)] = +$20,000 intrinsic value on June 17 [(+1.13 time value rate)($2500)(25 contracts)] = +$70,625 time value on June 17 [(1.45 total) ($2500)(25 contracts)] = +$20,000 intrinsic value + $70,625 time value = $90,625 FloorIT Page 7 5. What is the balance sheet asset or liability for the Option account's current value reported on August 31 for the 25 contracts purchased by FloorIT Corporation on June 17? Assume the 25 options qualify as a cash flow interest rate flooring hedge of the forecasted loan transaction's interest rate. Also assume SFAS 133 rules are in effect for valuing derivative financial instruments. Hint: The spot premium value per call option contract is given near the bottom of Exhibit 1 as 0.90 for August 31. The spot LIBOR rate is 4.70%. The balance sheet value is to be marked to-market at $56,250 = ($2,500)(0.90)(25 contracts). This represents a decrease of $34,375 from $90,625 to $56,250 due to a spot premium decrease from 1.45% to 0.90% between June 17 and August 31 using Exhibit 1 data. FloorIT Page 8 6. Using Exhibit 1 data, what is the balance sheet amount reported in other comprehensive income (OCI) on August 31for the 25 contracts purchased on June 17 in Question 1? Assume the 25 contracts qualify as a cash flow interest rate flooring hedge of the forecasted loan transaction's interest rate. Hint: Intrinsic value is discussed in Bob Jensen’s SFAS 133 and IAS 39 Glossary. An illustration of intrinsic value versus time value accounting is given in Example 9 of SFAS 133, Pages 84-86, Paragraphs 162-164. [(5.50% strike – 5.18% LIBOR)] [1.45% total - (+0.32% intrinsic)] = +0.32% intrinsic value portion of 1.45% June 17 premium = +1.13% positive time value portion of 1.45% June 17 premium [(0.32 intrinsic value rate)($2500)(25 contracts)] = +$20,000 intrinsic value on June 17 [(+1.13 time value rate)($2500)(25 contracts)] = +$70,625 time value on June 17 [(1.45 total) ($2500)(25 contracts)] = -$20,000 intrinsic value + $70,625 time value = $90,625 Since the above intrinsic and time values are not recorded on the date of acquisition, the starting value in OCI = $0. There is no current earnings adjustment for time value on June 17. Options Contracts is debited for $90,625 and Cash is credited for $90,625. In subsequent calculations it will be assumed that time value is $53,121 for a plug into the equations below. ----------------------------------------------------------------------------------------------------------------------------- ---[(5.50% strike – 4.70% LIBOR)] [0.90% total - (+0.80% intrinsic)] = +0.80% intrinsic value portion of 0.90% August 31 premium = +0.10% positive time value portion of 0.90% Aug. 31 premium [(+0.80% intrinsic value rate)($2500)(25 contracts)] = +$50,000 intrinsic value on August 31 [(+0.10% time value rate)($2500)(25 contracts)] = +$ 6,250 time value on August 31 [(0.90% total) ($2500)(25 contracts)] = +$50,000 intrinsic value + $6,250 time value = $56,250 Change in intrinsic value = +$50,000 - ($0) = +$50.000 between June 17 and Aug. 31 Change in time value = +$6,250 – $90,625 = -$84,375 between June 17 and Aug. 31 Change in total value = $56,250 - $90,625 = -$34,375 between June 17 and Aug. 31 Change in intrinsic value Change in earnings Change in total value = +$50,000 - ($0) = +$50,000 = -$34,375 - (+$50,000) = -$15,625 = $56,250 - $90,625 = -$34,375 between June 17 and Aug. 31 between June 17 and Aug. 31 between June 17 and Aug. 31 --------------------------------------------------------------------------------------------------------------------------------All of the $50,000 intrinsic value is reported as other comprehensive income (OCI) under SFAS 133 rules for this cash flow hedge using 25 call option contracts. The remainder of the increase in total value is the -$15,625 degradation of time value that is debited to current earnings (through Interest Expense). [ $50,000 credit bal. in OCI + $6,250 time value = $56,250. option value on August 31]. FloorIT Page 9 7. Discuss the outcome of all transactions through December after Pete Boniff’s decision to floor the hedge at a 9,450-strike price. For example, what is the net cost of the hedged interest on $25 million if LIBOR drops to 4% on September 17? What is the net cost if LIBOR drops to 3%? Pete Boniff decided to pay $90,625 on June 17 for the piece of mind of converting a variable loan rate of LIBOR+0.45% to a minimum fixed (floored) rate of 4.50%. If LIBOR drops to 4.00%, the net interest revenue will be ($25,000,000)(4.50%)(3/12 yr) = $281,250. . The hedged revenue is fixed at $281,250 for any value of LIBOR below the 5.50% strike rate, which is sometimes called the kink rate for reasons that will become obvious when you graph the loan rates as a function of LIBOR movements. Thus the hedged cost is $281,250 for a 2.00% LIBOR, a 3.00% LIBOR, and a 4.50% LIBOR on September 17 8. What is the net revenue of the hedged interest on $25 million if LIBOR is 5.49% on September 17? Hint: The 5.49% spot rate is only one tick below the strike rate of 5.50% APR. Recall that the strike rate is 5.50% corresponding to the strike rate of 9,450 basis points. The floor rate from the Question 1 answer is 4.50% after factoring in the cost (premium) of the call option at the 9,450-strike price having a strike rate of 5.50%. [ +($25,000,000)(5.49% + 0.45%)(3/12 yr) [ +($25,000,000)(5.50% - 5.49%)(3/12 yr) [ -($2,500)(1.45 cost of the options) ] = +$371,250 interest revenue from the loan = +$ 625 settlement of the 25 call options = -$ 90,625 aggregate premiums on June 17 Net revenue from all transactions = +$373,750 + $625 - $90,625 Recall that the floored hedge revenue = ($25,000,000)(4.50%)(3/12 yr) = $281,250 = $281,250 When the call option is only slightly in-the-money, FloorIT Bank exactly attains its floor rate of interest under the call hedge. What is the net lending rate APR after the settlement of the 25 call hedging contracts are factored into the calculation based upon a September 17 LIBOR of 5.49%? [($281,250/$25,000,000)(12/3 quarters) = 4.50% which is exactly equal to the hedged floor rate of 4.50%. FloorIT Page 10 9. What is the net revenue of the hedged interest on $25 million if LIBOR is 5.51% on September 17? Hint: The 5.51% spot rate is only one tick above the strike rate of 5.50% APR. Recall that the strike rate is 5.50% corresponding to the strike rate of 9,450 basis points. The floor rate from the Question 1 answer is 4.50% after factoring in the cost (premium) of the call option at the 9,450-strike price having a strike rate of 5.50%. [ +($25,000,000)(5.51% + 0.45%)(3/12 yr) [ +($25,000,000)(0 since LIBOR>5.50%) [ -($2,500)(1.45 cost of the options) ] = +$372,500 interest revenue from the loan =+$ 0 settlement of the 25 call options = -$ 90,625 aggregate premiums on June 17 Net revenue from all transactions = +$372,500 + $0 - $90,625 Recall that the floored hedge revenue = ($25,000,000)(4.50%)(3/12 yr) = $281,875 = $281,250 When the call option is only slightly out-of-the-money, FloorIT Bank can obtain slightly more than the floor earnings on the $25,000,000 loan. What is the net lending rate APR after the settlement of the 25 call hedging contracts are factored into the calculation based upon a September 17 LIBOR of 5.51%? [($281,875/$25,000,000)(12/3 quarters) = 4.51% which is slightly greater than the hedged floor rate of 4.50%. 10. What is the net revenue of the hedged interest on $25 million if LIBOR is 6.50% on September 17? Hint: Recall that the strike rate is 5.50% corresponding to the strike rate of 9,450 basis points. The floor rate from the Question 1 answer is 4.50% after factoring in the cost (premium) of the call option at the 9,450-strike price having a strike rate of 5.50%. [ +($25,000,000)(6.50% + 0.45%)(3/12 yr) [ +($25,000,000)(0 since LIBOR>5.50%) [ -($2,500)(1.45 cost of the options) ] = +$434,375 interest revenue from the loan =+$ 0 settlement of the 25 call options = -$ 90,625 aggregate premiums on June 17 Net revenue from all transactions = +$434,375+ $0 - $90,625 Recall that the floored hedge revenue = ($25,000,000)(4.50%)(3/12 yr) = $343,750 = $281,250 When the call option is high out-of-the-money, FloorIT Bank can obtain significantly more than the floor earnings on the $25,000,000 loan. What is the net lending rate APR after the settlement of the 25 call hedging contracts are factored into the calculation based upon a September 17 LIBOR of 6.50%? [($343,750/$25,000,000)(12/3 quarters) = 5.50% which is much greater than the hedged floor rate of 4.50%. FloorIT Page 11 11. What is the net revenue of the hedged interest on $25 million if LIBOR plunges to 3.00% on September 17? Given that it hedged its revenue at a floor amount of $281,250, what does LIBOR have to be for the FloorIT Bank to earn more than this floor rate? Hint: Recall that the strike rate is 5.50% corresponding to the strike rate of 9,450 basis points. The floor rate from the Question 1 answer is 4.50% after factoring in the cost (premium) of the call option at the 9,450-strike price having a strike rate of 5.50%. [ +($25,000,000)(3.00% + 0.45%)(3/12 yr) [ +($25,000,000)(5.50% - 3.00%)(3.12 yr) [ -($2,500)(1.45 cost of the options) ] = +$215,625 interest revenue from the loan = +$156,250 settlement of the 25 call options = -$ 90,625 aggregate premiums on June 17 Net revenue from all transactions = +$215,625 + $156,250 - $90,625 Recall that the effective floor revenue = ($25,000,000)(4.50%)(3/12 yr) = $281,250 = $281,250 Since FloorIT Bank hedged at a 4.50% effective floor rate, it really does not matter how low LIBOR plunges below that point. However, when the flooring options go out-of-the-money (i.e., when LIBOR exceeds 5.50%), the bank can earn more than the floor rate. It only earns the floored revenue of $281,250 if LIBOR does not rise above the strike rate of 5.50%. What is the net lending rate APR after the settlement of the 25 call hedging contracts are factored into the calculation based upon a September 17 LIBOR of 3.00%? [($281,250/$25,000,000)(12/3 quarters) = 4.50% which is equal to the hedged floor rate of 4.50%. 12. Compute value of the adjustment (A) in the equation below that derives the FloorIT Corporation lending rate whenever the call options are in the money: R = LIBOR R = 4.50% A % for LIBOR >5.50% for LIBOR <5.50% R = LIBOR - 1.00% for LIBOR >5.50% R = 4.50% for LIBOR <5.50% 13. Draw a graph showing the loan rate net of the hedging impact. In other words, graph the floored rate up to the kink point and then show the rising loan rate after the kink point. The graph’s abscissa should show possible values of the September 17 LIBOR ranging from 2.00% to 10.0%. The graph’s ordinate should show the net loan rate. Hint: The net loan rate will be linear (i.e., LIBOR+0.45%) after the kink point. Prior to that kink point it remains flat at the floored interest rate resulting from the purchase of 25 call option contracts on June 17 at a strike price of 9,450 as shown in Exhibit 1. This results in a net loan rate that has the typical hedged “hockey stick” shape. _____________________________________________________________________________________ Insert Exhibits 2 and 3 About Here _____________________________________________________________________________________ FloorIT Page 12 14. FloorIT Bank may have chosen any of the available strike prices shown for call options in Exhibit 1. Draw a graph showing the loan rates net of the hedging impact for September options having strike prices of 9,425 versus 9,450 versus 9,475 basis points. In other words, graph the loan rates up to the kink points and then show only the floored rates after the kink points. The graph’s abscissa should show possible values of the September 17 LIBOR ranging from 2.00% to 9.00%. The graph’s ordinate should show the net loan rates of the three strike price choices. See Exhibit 3. Based upon the outcomes in the graph, does it appear that Pete Boniff made an optimal hedge for FloorIT Bank? Hint: Look at your answers to Question 1. For a lower cost of $25,000, he could have obtained a 5.30% effective floor rate using the 9,475 strike price corresponding a strike interest rate of 5.25% APR. For a mere $6,250, he could have a floor rate of 5.35% having a strike price of 9,500. His 9,450-strike price call option (costing $90,625) ended up with an effective floor rate of 4.50. Pete Boniff made a bad choice. He would have been much better off paying only $6,250 for the highest effective floor rate of 5.35%. Not only is the floor rate higher, he would have saved $90,625 - $6,250 = $84,375. 15. The Exhibit 1 premium for the September call option using the 9,500-strike price is 0.10% that translates into a $25,000 cost of 25 hedging contracts on June 17. Its effective floor rate is 5.35%. The premium for the September call option using the 9,450-strike price is 1.45% that translates into a $90,625 cost of 25 hedging contracts on June 17. Its effective floor rate is only 4.50%. What would the market premium in Exhibit 1 have to have been for the 9,450-strike price to become an effective floor rate of 5.35%? In that circumstance, how much would the hedge cost have to be in lieu of the $90,625 cost actually paid by FloorIT Bank on June 17? 9,450 call strike price floor rate = 5.50% +0.45% - 0.60% premium 9,500 call strike price floor rate = 5.00% +0.45% - 0.10% premium = 6.45% APR = 5.35% APR The market set the premium at 1.45% APR. This would have to fall to 0.60% if the 9,450-strike price would become as good for hedging purposes as the 9,500-strike price. If the market price fell to 0.60%, the hedging cost would fall from $90,625 to $37,500 as computed below: [(1.45)($2500)(25 call contracts)] = $90,625 for a strike rate of (10,000 – 9,450)/100 = 5.50% APR [(0.60)($2500)(25 call contracts)] = $37,500 for a strike rate of (10,000 – 9,450)/100 = 5.50% APR FloorIT Page 13 16. If the September call option premium had been 0.50 instead of 1.45 for the 9,450-strike price in Exhibit 1, what would the optimal choice have been for Pete Boniff to floor the borrowing rate on the $25 million loan? Consider both the choice ex ante on June 17 and outcome ex post given the September 17 LIBOR of 4.50% APR. Hint: Review your answers to Question 1. Since interest rates are uncertain, the “optimal” cap rate is no longer obvious. The cost of the 9,450-strike price call option is compared with the 9,500 strike-price premium as follows: [(0.50)($2500)(25 call contracts)] = $31,250 for a strike rate of (10,000 – 9,450)/100 = 5.50% APR [(0.10)($2500)(25 call contracts)] = $ 6,250 for a strike rate of (10,000 – 9,500)/100 = 5.00% APR The effective floor rates are as follows for all Exhibit 1 alternatives are as follows: 9,450 call strike price floor rate = 5.50% +0.45% - 0.50% premium 9,500 call strike price floor rate = 5.00% +0.45% - 0.10% premium = 5.45% APR = 5.35% APR In this revised example, FloorIT Bank can get a 5.35% effective lending floor at the lowest June 17 cost of $6,250. However, it can get a higher effective floor rate of 5.45% if it is willing to pay $31,250. The choices are thus to either have the highest cap or the lowest cost. We need to know more about the probabilities of LIBOR movements after June 17 to assess optimality ex ante. It is impossible to choose the “optimal” ex ante decision when the 9,450-strike price premium is only $31,250 for a 0.50% premium having an effective floor of 5.45%. However, in Exhibit 1the 9,450-strike price was actually $90,625 from a 1.45% premium and an effective floor of 4.50%, Pete Boniff made a poor ex ante choice on June 17. The 9,500-price is always better given the CME market premiums in Exhibit 1. 17. Hedging a lending rate via a call option is only one of several alternatives for hedging a lending rate. Other alternatives include interest rate swaps and interest rate forwards and futures. What is the main advantage of options in hedging strategies? The main advantage of options is that the risk is known and fixed at an amount equal to the initial level of investment in the purchase cost of the options contracts. For example, when FloorIT purchased 25 call contracts for $90,625 on June 17, the maximum harm done no matter what happens is a loss of $90,625 on the call options. In other hedging interest rate forward/futures contracts, the initial investment may be almost zero, but the loss risk may soar with big changes in LIBOR. . Futures and forward contracts expose the holder to enormous risks. Options holders have no risks beyond the cost of the options. Purchases of hedging options are quick and easy if satisfactory deals are traded on open exchange systems such as the Chicago Board of Options Exchange. Interest rate swaps have the advantage of both having a low initial cost and fixed risk if a variable rate of interest is swapped for a fixed rate. The problem with interest rate swaps is that they are custom contracts in which counter parties to the swap must be located and dealt with in private or brokered negotiations. Also it is better if the swap periods coincide. On June 17, FloorIT has no interest payments to swap. FloorIT Page 14 18. Given the premium values at the bottom of Exhibit 1, show the journal entries that are required under SFAS 133 and IAS 39 for June 17, June 30, July 31, and September 17. Assume the books are closed at the end of each calendar year. _____________________________________________________________________________________ Insert Exhibit 4 About Here _____________________________________________________________________________________ When solving this part of the case, it is best to compute the value of the derivative instruments (25 option contracts) and then partition this value into intrinsic value versus time value components. Readers are referred to Example 9 of SFAS 133, Pages 84-86, Paragraphs 162-164. Readers may also want to look up key terms in Bob Jensen's SFAS 133 and IAS 39 Glossary at http://WWW.Trinity.edu/rjensen/acct5341/speakers/133glosf.htm . Using the hypothetical value changes at the bottom of Exhibit 1, the hedging contract value can be derived as shown below: [(1.45% spot premium on June 17)($2500)(25 contracts) [(1.58% spot premium on June 30)($2500)(25 contracts) [(1.10% spot premium on July 31)($2500)(25 contracts) [(0.01% spot premium on Aug. 31)($2500)(25 contracts) [(0.00% spot premium on Sep. 17)($2500)(25 contracts) = $90,625 asset value = $98,750 asset value = $68,750 asset value = $ 6,250 asset value =$ 0 asset value The changes in time values and intrinsic values can be derived as follows: [(5.50% strike – 5.18 LIBOR)] [1.45% total - (+0.32% intrinsic)] = +0.32% intrinsic value portion of 1.45% June 17 premium = +1.13% positive time value portion of 1.45% June 17 premium [(+0.32 intrinsic value rate)($2500)(25 contracts)] = +$20,000 intrinsic value on June 17 [(+1.13 time value rate)($2500)(25 contracts)] = +$70,625 time value on June 17 [(1.45 total) ($2500)(25 contracts)] = +$20,000 intrinsic value + $70,625 time value = $90,625 Since the above intrinsic and time values are not recorded on the date of acquisition, the starting value in OCI = $0. There is no current earnings adjustment for time value on June 17. The Options Contracts account is debited for $90,625 and Cash is credited for $90,625. In subsequent calculations it will be assumed that time value is $90,625 for a plug into the equations below. -------------------------------------------------------------------------------------------------------------------------------[(5.50% strike) – 5.10%] [1.58% total - (+0.4000% intrinsic)] = +0.40% intrinsic value portion of 1.58% June 30 premium = +1.18% positive time value portion of 1.58% June 30 premium [( +0.40 intrinsic value rate)($2500)(25 contracts)] = +$25,000 intrinsic value on June 30 [(+1.18 time value rate)($2500)(25 contracts)] = +$73,750 time value on June 30 [(1.58 total) ($2500)(25 contracts)] = +$25,000 intrinsic value + $73,750 time value = $98,750 Change in intrinsic value = +$25,000 - ( +$20,000) = +$ 5.000 between June 17 and June 30 Change in time value = +$73,750 - (+$70,625) = +$ 3,125 between June 17 and June 30 Change in total value = $34,375 - $90,625 = +$ 8,125 between June 17 and June 30 Change in OCI Change in earnings Change in total value = +$25,000 - (-$0) = +$8,125 - (+$25,000) = $34,375 - $90,625 = +$25,000 = -$16,875 = +$ 8,125 between June 17 and June 30 between June 17 and June 30 between June 17 and June 30 FloorIT Page 15 ----------------------------------------------------------------------------------------------------------------------------- --[(5.50% strike – 5.38 LIBOR)] [1.10% total - (+0.12% intrinsic)] = +0.12% intrinsic value portion of 1.10% July 31 premium = +0.98% positive time value portion of 1.10% July 31 premium [(+0.12 intrinsic value rate)($2500)(25 contracts)] = +$ 7,500 intrinsic value on July 31 [(+0.98 time value rate)($2500)(25 contracts)] = +$61.250 time value on July 31 [(1.10 total) ($2500)(25 contracts)] = +$7,500 intrinsic value + $61,250 time value = $68,750 Change in intrinsic value = +$ 7,500 - (+$25,000) = -$17,500 between June 30 and July 31 Change in time value = +$61,250 - (+73,750) = -$12.500 between June 30 and July 31 Change in total value = $68,750 - $98,750 = -$30,000 between June 30 and July 31 Change in OCI Change in earnings Change in total value = +$ 7,500 - (+$25,000) = = +$30,000 - (-$17,500) = = $68,750 - $98,750 = -$17,500 -$12,500 -$30,000 between June 30 and July 31 between June 30 and July 31 between June 30 and July 31 ----------------------------------------------------------------------------------------------------------------------------- --[(5.50% strike- 4.70% LIBOR)] = +0.80% intrinsic value portion of 0.90% August 31 premium [0.90% total - (+0.80% intrinsic)] = +0.10% positive time value portion of 0.90% Aug. 31 premium [(+0.80 intrinsic value rate)($2500)(25 contracts)] = +$50,000 intrinsic value on August 31 [(+0.10 time value rate)($2500)(25 contracts)] = +$ 6,250 time value on August 31 [(0.10 total) ($2500)(25 contracts)] = +$50,000 intrinsic value + $6,250 time value = $56,250 Change in intrinsic value = +$50,000 - (+$ 7,500) = +$42,500 between July 31 and August 31 Change in time value = +$ 6,250 - (+$61,250) = -$55,000 between July 31 and August 31 Change in total value = $56,250 - $68,750 = -$12,500 between July 31 and August 31 Change in OCI Change in earnings Change in total value = +$50,000 - ( +$ 7,500) = + $42,500 = -$12,500 - (+$42,575) = -$55,000 = $56,250 - $68,750 = -$12,500 between July 31 and August 31 between July 31 and August 31 between July 31 and August 31 -------------------------------------------------------------------------------------------------------------------------------[(0.00% total) ($2500)(25 contracts)] = +$0 intrinsic value + $0 time value = $0 Change in intrinsic value = +$0 - ( +$50,000) = -$50,000 between Aug. 31 and Sept. 17 Change in time value = +$0 - ( +$ 6,250) = -$ 6,250 between Aug. 31 and Sept. 17 Change in total value = +$0 - (+$56,250) = -$56,250 between Aug. 31 and Sept. 17 Change in OCI = $0 - ( -$50,000) Change in earnings = $93,750 settlement - $56,250 - (-$50,000) Change in total value = +$0 - (+$56.250) = +$50,000 Aug. 31-Sept. 17 = -$87,500 Aug. 31-Sept. 17 = -$56,250 Aug. 31-Sept. 17 --------------------------------------------------------------------------------------------- ----------------------------------September 17 settlement at LIBOR=4.20% becomes (5.50%-4.00%)($25m)(3/12 yr) Less the June 17 cost (premium) for 25 hedging option contracts = -(1.45)($2,500)(25) Net income on the 25 hedging option contracts having a 9,450-strike price = $93,750 = - 90,625 = $ 3,125 Alternately, this can be computed with the tick rate’s annualized $10,000 scaling factor as follows: September 17 settlement at LIBOR=4.20% becomes (5.50%-4.00%)($25m)(3/12 yr) Less the June 17 cost (premium) for 25 contracts = -(1.45%)($10,000)(25) (3/12 yr) Net income on the 25 hedging option contracts having a 9,450-strike price = $93,750 = - 90,625 = $ 3,125 FloorIT Page 16 Net interest on $25 million from September 17 to December 17 at 4.00% spot rate+0.45% Net revenue of hedged loan = $278,125 revenue + $3,125 hedge Proof calculation = ($25,000,000)(4.50% floor rate)(0.25 yr) = $278,125 = $281,250 for three months = $281,250 for three months What is the net lending rate APR after the settlement of the 25 call hedging contracts are factored into the calculation based upon a September 17 LIBOR of 4.00%? [($281,250/$25,000,000)(12/3 quarters) = 4.50% which is equal to the hedged floor rate of 4.50%. 19. The accounting in Exhibit 4 is in conformance with SFAS 133 rules that require splitting changes in option values between Other Comprehensive Income (for changes in intrinsic value) and current income (for changes in time value). How would the journal entries change to conform to IAS 39 of the International Accounting Standards Committee (IASC)? Hint: See Paul Pacter's commentary at http://www.iasc.org.uk/news/cen8_142.htm . You can also read more of Paul Pacter's comments at http://WWW.Trinity.edu/rjensen/acct5341/speakers/pacter.htm . The only change is that all amounts recorded to OCI in Exhibit 4 would instead be combined with Interest Expense (Revenue) amounts. IAS 39 does not have an OCI requirement comparable to that the OCI requirements in SFAS 130 and SFAS 133. In England, the OCI reconciliation statement is called a "Struggle Statement." However, the IASC does not yet require OCI and Struggle Statements. You can read more about OCI under the definition of Other Comprehensive Income and Struggle Statements in http://WWW.Trinity.edu/rjensen/acct5341/speakers/133glosf.htm FloorIT Page 17 It was stressed initially that the $25 million loan was a “forecasted transaction.” How would the journal entries change if there was a “firm commitment” for FloorIT to borrow the $25 million on September 17? Is the distinction between firm commitments versus forecasted transactions as relevant on the international IAS 39 standard as it is in the U.S. SFAS 133 standard? Hint; The terms “forecasted transaction” and “firm commitment” have important distinctions in SFAS 133. You may find references to parts of that standard by looking up these terms in http://WWW.Trinity.edu/rjensen/acct5341/speakers/133glosf.htm#0000Begin . Paragraph 540 on Page 244 of SFAS 133 defines a “firm commitment” as follows: An agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics: a. The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity's functional currency or of a foreign currency. It may also be expressed as a specified interest rate or specified effective yield. b. The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable. The key is the term “fixed price.” Even if FloorIT Bank signed an iron-clad contract to lend $25 million on September 17, the variable rate of LIBOR+0.45% is not a “fixed price.” But if the contract were to be rewritten at a fixed price, there would be no uncertain interest rate to hedge. If the transaction is re-written to be a firm commitment as defined above, the only hedge accounting allowed for any firm commitment is a fair value hedge rather than a cash flow hedge. Cash flow hedges are only allowed for forecasted transactions. If FloorIT instead had a firm commitment to lend the $25 million on September 17, all entries to OCI in Exhibit 4 would be transferred to Interest Expense (Revenue) or some other current earnings account. Changes in intrinsic value may not be placed in OCI when there is a firm commitment. The FASB reasoned that the transaction is effectively consummated when there is a firm commitment and all gains and losses should be recognized in the current period. Only when the transaction is not effectively consummated (by being only a forecasted transaction that can be gotten out of a little or no cost) can gains and losses be “deferred” in OCI until the transaction actually takes place on September 17. Since the IASC does not allow an OCI account in IAS 39, forecasted transactions and firm commitments are treated alike in the international standard. This is not the case in the United States, however, since SFAS 133 will allow credits to OCI for the intrinsic value changes of forecasted cash flows. One difference that is sometimes overlooked in IAS 39 international rules is that some fair value and forecasted transactions hedges do not have to be adjusted to fair value if they qualify as “held-to-maturity” financial instruments. In that case, the call options purchased by FloorIT Bank could be maintained on the books at historical cost ($90,625) until the options are settled at the September 17 maturity date. SFAS 133 requires that they be marked-to-market as derivative financial instruments whether or not they qualify as hedges. FloorIT Page 18 20. FloorIT Bank has a policy of never investing in options as speculations. Call options such as those illustrated in this case are always “held to maturity” up to the time the hedged loan transpires. Pete Boniff argued that the IAS 39 does not require adjusting derivatives to current value if they are intended to be held to maturity. Under IAS 39, should the Exhibit 4 journal entries be changed so that the options remain from June 17 until September 17 at their historical cost of $90,625? IAS 39 does not allow derivative financial instruments to be maintained at historical cost if the investor is not reasonably certain to recover the initial cost. In the case of 25 call options on a forecasted loan transaction, there are all sorts of uncertainties. First and foremost, there is the uncertainty that the forecasted loan will never transpire. If that happens, FloorIT Bank ends up with having to take whatever speculative gain or loss it gets when the option contracts are settled. There is no assurance that high interest revenue from a variable rate loan will cover the cost of the options if the loan does not transpire. In my viewpoint, the IAS 39 rule applies more to situations where there is little or no market risk. For example, in an interest rate swap, the initial investment is usually zero. If the investor has a policy of holding such swaps to maturity accompanied by a track record of living up to this policy, a case can be made for not adjusting the swaps to market value during the term of the swap. In fact, I have argued elsewhere that adjusting such swaps to fair value creates misleading fluctuations in assets and liabilities. But this argument does not extend to options contracts used to hedge forecasted transactions.