Download Case Objectives - Trinity University

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.
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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
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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
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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
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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
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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
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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.
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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].
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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%.
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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.