133 Ex A

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Bob Jensen's web site is at http://www.trinity.edu/~rjensen

Example 5 of SFAS 133, pp. 72-76, Paragraphs 131-138.
Cash Flow Hedge of Variable-Rate Interest-Bearing Asset
Statement on derivatives is available as Publication Number 186-B, June 1998, Product Code S133
FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities
Call (800) 748-0659 or go to web site http://www.rutgers.edu/Accounting/raw/fasb/home2.html
Copies are $11.50 each and are subject to academic discounting.
SFAS 133 replaces the Exposure Draft publication Number 162-B, June 1996
Questions This is Bob Jensen's answer file.

Example 5 of SFAS 133, Page 74, Paragraphs 133 and 134
SFAS 133 Paragraph 133.
On July 1, 20X1, XYZ Company invests $10,000,000 in variable-rate corporate bonds that
pay interest quarterly at a rate equal to the 3-month US$ LIBOR rate plus 2.25 percent.
The $10,000,000 principal will be repaid on June 30, 20X3.
SFAS 133 Paragraph 134
Also on July 1, 20X!, XYZ enters into a two-year receive-fixed, pay variable interest rate
swap and designates it as a cash flow hedge of the variable-rate interest receipts on
corporate bonds. The risk designated as being hedged is the risk of changes in cash flows
attributable to changes in market interest rates.
SFAS 133 Terminology is defined and linked in Bob Jensen's SFAS 133 Glossary
Prior to assigning the questions below, students are given the Sheet 2 journal entries with some
numbers missing (red question marks). Their first task is to complete Sheet 2.
1
1
1
1
1
1
1
= Question Number
What paragraphs in SFAS 133 (other than Paragraphs 104-293) prescribe the
ineffective hedge treatment journal entries in Example 5?
Summarize the prescribed rule for this fair value hedge of a forecasted
transaction.
Paragraph 30 on Page 20 of SFAS 133 states: "The effective portion of the
1
gain or loss on a derivative designated as a cash flow hedge is reported in other
1
comprehensive income, and the ineffective portion is reported in earnings."
1
1
The above rule is elaborated upon in Paragraphs 30-35 and 374-379.
1
2
2
= Question Number
2
What is meant by a "cash flow hedge" of a variable rate investment? Explain
2
in terms of the Example 5 in Sheet 2. How effective is the Example 5 swap?
2
Create a chart showing the bond revenue and swap cash flows each quarter.
2
Compare the rates of return with or without a cash flow hedge.
2
2
In Example 5, the XYZ Company's bond investment has a variable return based
2
upon LIBOR plus 2.25%. An effective interest rate swap receiving fixed and
2
paying variable swap rates can turn the combined bond plus swap cash
2
flows into constant cash net cash flows each period. That is the most common
2
form of swap hedging of variable interest rates.
Yellow = Swap Revenue % of Total
2
100%
2
2
Bond
Interest
Net
90%
2
Interest
Swap
Hedged
80%
2
Quarter
Revenue
Revenue
Revenue
0
$0
$0
$0
2
70%
1
$195,250
$27,250
$222,500
2
60%
2
$197,000
$25,500
$222,500
2
3
$195,250
$27,250
$222,500
2
50%
4
$193,000
$29,500
$222,500
2
40%
5
$225,000
($2,500)
$222,500
2
6
$227,750
($5,250)
$222,500
2
30%
7
$230,500
($8,000)
$222,500
2
20%
8
$220,500
$2,000
$222,500
2
Total
$1,684,250
$95,750
$1,780,000
2
10%
Hedged Versus2Unhedged Yields
0%
2
2
Without a swap, XYZ Company only get $1,684,250 from its variable rate bonds.
2
With the swap XYZ received an added $95,750 and, thereby, avoided nearly 6% in a
2
loss of bond interest revenue due to so many quarters in which LIBOR is below
2
the 6.65% APR that XYZ pays out in fixed payments on the swap. The cost
2
of this protection is 6.65% or 6.65$/4 = 1.6625% each quarter making the
2
total swap cost $166,250 each quarter.
2
2
Actually XYZ has gambled that
interest rates will consistently fall below the 6.65%
LIBOR Plus 2.2500%
2
APR swap rate over the nextHedged
two years.
Higher interest rates will wipe out the
Annual Return
2
opportunity value of the variable returns of the bond investment of $10 million.
2
2
However, if XYZ is happy with the flat $222,500 combined bond and swap
2
revenue each quarter, the interest rate swap has taken the risk out of falling
2
interest rates that would otherwise have reduced the variable bond revenues.
2
2
2
4
The XYZ Company had an Example 5 choice of keeping variable interest rate risk of LIBOR plus 2.25% flowing in on the $10 million
6 investment versus
7
bond
hedging8for a fixed $225,200 return each quarter. This translates to a quarterly return of 2.252% on the $10
million, which in turn is a fixed annual yield of 9.00% APR. A graph of the two possible outcomes with hindsight is as follows:
25
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
3
3
3
3
3
3
3
3
3
3
4
6 investment versus
7
bond
It is likely that the XYZ Company either anticipated falling LIBOR spot rates or was very risk averse to variable interest rate risk in
general. In either case, XYZ was willing to trade bond investment value (that is fixed with an unhedged cash flow risk) for a variable
investment value that had a fixed rate of return yield of 9.00% per year on the $10 million investment.
FAS 133 allows for the effective portion of a cash flow hedge to be debited or credited to Other Comprehensive Income (OCI) rather
than current earnings. Since the bond interest yield and the hedge cash flows are perfectly correlated with changes in LIBOR spot
rates, there cannot be any hedge ineffectiveness. In fact, such a hedge qualifies for the Short Cut Method in FAS 133. This means that
XYZ Company can initially declare the hedge to be perfectly effective and, thereafter, need not test for ineffectiveness.
= Question Number
In the table in Paragraph 137 on Page 75 of SFAS 133, why does the reported
earnings value fluctuate so much from quarter to quarter?
That is because the table presented in Example 5 of SFAS 133 does not show the
revenue each quarter from the bond investment. If that variable amount is
included the combined earnings each quarter is $225,000 as illustrated in
my Sheet 2 journal entries.
4
4
4
4
4
4
4
4
4
4
4
4
4
4
4
4
4
4
5
5
5
5
5
5
5
5
5
5
6
6
6
6
6
6
6
6
6
6
6
6
6
6
7
7
7
7
7
7
7
7
7
= Question Number
What is missing in SFAS 133 for computation of the interest accruals shown in the
table in Paragraph 137 on Page 74? For example, why can't readers of SFAS 133
derive the interest accruals 330, 1210, 870, 670, 440, and 40?
See Sheet 4. Also see the comments on the various cells in Sheet 2.
The FASB decided not to provide the yield curve for any example in SFAS 133
and not to explain alternative methods of computing accruals derived from yield
curves. You can read more about this at the following web document:
http://www.cs.trinity.edu/~rjensen/133accr.htm
Yield curves are defined at the following web site:
http://www.cs.trinity.edu/~rjensen/133glosf.htm
= Question Number
When you compare Page 65 of Example 2 with Page 75 of Example 5 in SFAS 133,
you notice that basis adjustments are amortized in Page 65 but not in Page 75.
Please explain the reason why.
Example 2 is a fair value hedge in contrast to the cash flow hedge in Example 5.
In reality, it does not much matter since effects of rate changes are plugged for
the differences whether or not the amortization is actually measured.
= Question Number
Are the interest accruals computed by the FASB on Page 75 of Example 5 compatible
with the swap values computed by the FASB on Page 75 of FAS 133?
The answer is no. You can make comparisions by looking at the FASB versus Jensen Pg 75
Jensen spreadsheets in this workbook. The Jensen Pg. 75 revisions
assume the swap values are correct and recalculates the interest accruals.
= Question Number
How were the swap valuations derived by the FASB each quarter?
The FASB did not calculate the swap valuations using appropriate yield (swap) curves.
In fact, the swap valuations in Example 5 are totally inconsistent with the swap cash flows.
The botton below leads to a corrected Example 5 using more appropriate swap valuations.
7
7
8
8
8
8
= Question Number
You must be able to describe how to compute any number in the other spreadsheets in this Excel workboo
wap Revenue % of Total
e $10 million
on the $10
ollows:
e $10 million
on the $10
ollows:
rate risk in
or a variable
OCI) rather
BOR spot
his means that
ets in this Excel workbook.
Analysis Assuming a Perfect Hedge With No Ineffectiveness

Example 5 of SFAS 133, pp. 72-76, Paragraphs 131-138
Paragraph 137 Data of SFAS 133 (No ineffectiveness)

Annual
LIBOR
LIBOR
Plus
Quarter
Rate
2.2500%
0
5.5600%
7.8100%
1
5.5600%
7.8100%
2
5.6300%
7.8800%
3
5.5600%
7.8100%
4
5.4700%
7.7200%
5
6.7500%
9.0000%
6
6.8600%
9.1100%
7
6.9700%
9.2200%
8
6.5700%
8.8200%
Annual
Swap
Rate
6.6500%
6.6500%
6.6500%
6.6500%
6.6500%
6.6500%
6.6500%
6.6500%
6.6500%
Quarter
07/01/00
09/30/00
12/31/00
03/31/01
06/30/01
09/30/01
12/31/01
03/31/02
06/30/02
Note
Payoff
Bond
Proceeds
Summary of Cash Transactions

Bond
Interest
Interest Rate
Swap
Sources of Cash:
7/1/2000
Applications of Cash:
09/30/00
12/31/00
03/31/01
06/30/01
09/30/01
12/31/01
03/31/02
06/30/02
($10,000,000)
195,250
197,000
195,250
193,000
225,000
227,750
230,500
220,500
$1,684,250
27,250
25,500
27,250
29,500
(2,500)
(5,250)
(8,000)
2,000
$95,750
10,000,000
$10,000,000
$11,780,000
Quarterly
LIBOR
Rate
0.013900
0.013900
0.014075
0.013900
0.013675
0.016875
0.017150
0.017425
0.016425
LIBOR Plus 2.2500%

Hedged Annual Return
Net increase in cash =
$1,780,000
Scroll down slowly and try to follow the logic of a fair value hedge.
A glossary of FAS 133 terminology is available at
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
6 investment versus
7
bond
It is likely that the XYZ Company either anticipated falling LIBOR spot rates or was very risk averse to variable interest rate risk in
general. In either case, XYZ was willing to trade bond investment value (that is fixed with an unhedged cash flow risk) for a variable
investment value that had a fixed rate of return yield of 9.00% per year on the $10 million investment.
FAS 133 allows for the effective portion of a cash flow hedge to be debited or credited to Other Comprehensive Income (OCI) rather
than current earnings. Since the bond interest yield and the hedge cash flows are perfectly correlated with changes in LIBOR spot
rates, there cannot be any hedge ineffectiveness. In fact, such a hedge qualifies for the Short Cut Method in FAS 133. This means that
XYZ Company can initially declare the hedge to be perfectly effective and, thereafter, need not test for ineffectiveness.
In the following table, the blue amounts asuumed in Example 2 beginning in Paragraph 111 of FAS 133
are filled in the cells. Students may, however, replace the following values with other numbers to study
the sensitivity of the outcomes to the input values.

Example 2 in FAS 133 assumes a perfect correlation between changes in the value of the Bond with
changes in spot rates for LIBOR. In real life, the correlation may be less than perfect. In the cells
below, it is possible to specify alternate Bond fair value such that the correlation in less than perfect.
Example 2 in FAS 133 assumes that the yield (swap) curve used to derive the swap receivable or
payable is flat. In real life, it is more common for parties to the swap to negotiate based upon a
nonlinear swap curve that allows for interest rate term structrure. Before beginning the illustration,
it will be helpful to explain how interest rate swaps are valued.
To better understand the yield (swap) curve factors, you may want to read the spreadsheet in
this workbook entitled "Yield Curve." For example, in that spreadsheet the following factors
are derived for the first swap fair value adjustment on September 30:
FASB's
FASB's
FASB's
FASB's
Ex Post
Ex Ante
Ex Ante
Ex Ante
Ex Ante
Bond
Yield Curve
Yield Curve
Yield Curve
Yield Curve
Date
Rates
Rate
Rate
Rate
Rate
07/01/00
09/30/00
5.56%
09/30/00
7.8100%
12/31/00
5.63%
5.63%
12/31/00
7.8800%
03/30/01
5.78%
5.56%
5.56%
03/31/01
7.8100%
06/29/01
5.93%
5.68%
5.47%
5.47%
06/30/01
7.7200%
6.07%
5.79%
5.59%
6.75%
09/30/01
9.0000%
6.22%
5.91%
5.70%
6.87%
12/31/01
9.1100%
6.37%
6.03%
5.82%
6.98%
03/31/02
9.2200%
6.52%
6.14%
5.94%
7.10%
06/30/02
8.8200%
Summary of Input to the Effectiveness Case Solution

You may change the values shown below in blue in order to test the sensitivity of the
Effectiveness Solution outcomes. In particular, you should compare patterns of rising versus
falling APR spot rates of interest (LIBOR).
Ex Post
Ex Post
Ex Ante
Ex Ante
Ex Ante
LIBOR
Bond
Yield Curve
Yield Curve
Yield Curve
Date
Spot
Rates
Rates
Rates
Rates
07/01/00
0.0556
09/30/00
09/30/00
0.0556
7.8100%
5.56%
12/31/00
12/31/00
0.0563
7.8800%
5.63%
5.63%
03/30/01
03/31/01
0.0556
7.8100%
5.78%
5.56%
5.56%
06/30/01
0.0547
7.7200%
5.93%
5.68%
5.47%
09/30/01
0.0675
9.0000%
6.07%
5.79%
5.59%
12/31/01
0.0686
9.1100%
6.22%
5.91%
5.70%
03/31/02
0.0697
9.2200%
6.37%
6.03%
5.82%
06/30/02
0.0657
8.8200%
6.52%
6.14%
5.94%
Swap Value =
$24,850
$73,800
$85,910
The swap outcomes are shown below:

Date
09/30/00
12/31/00
03/31/01
06/30/01
09/30/01
12/31/01
03/31/02
06/30/02
Fixed
Swap
Receivable
6.65%
6.65%
6.65%
6.65%
6.65%
6.65%
6.65%
6.65%
Ex Post
Bond
Rates
7.81%
7.88%
7.81%
7.72%
9.00%
9.11%
9.22%
8.82%
Quarterly
Swap
Rate
1.6625%
1.6625%
1.6625%
1.6625%
1.6625%
1.6625%
1.6625%
1.6625%
Ex Post
LIBOR Spot
Payable
1.3900%
1.4075%
1.3900%
1.3675%
1.6875%
1.7150%
1.7425%
1.6425%
Spot Rate
Relative to
July 1 Rate
100.0000%
101.2590%
100.0000%
98.3813%
121.4029%
123.3813%
125.3597%
118.1655%
The actual note values are compared with the estimated values below:
Note that from the borrower's point of view, a rise in interest rates leading to a decline in the market value of debt is good news. Unless a firm wants to
capture the windfall gain by buying back the debt, there is little economic incentive to refinance the debt at higher interest rates.
However, if interest rates plunge, the news may be viewed as both good and bad news. It is good news that interest rates are lower should the borrower elect
to refinance the debt at lower rates. However, there is a problem of buying back the existing debt at soaring market prices due to plunging interest rates.
It would seem that ABC Company, in Example 2 of FAS 133 beginning in Paragraph 111, anticipated falling interest rates. In that case, a hedge that locks in
the net value (high debt repurchase cost less the hedge gains) at $1,000,000 eliminates the risk of having to pay a very high price (e.g., $1,020,000) to pay off
the old debt before refinancing at lower spot rates.
The problem with the fair value hedge in Example 2 is that ABC Company had to take on cash flow risk (for the swap payments) in order to keep fair value
constant. The actual outcome illustrates how this can be a losing proposition. The interest rate swap hedge resulted in a net payout of $12,225 to keep the
loan value locked at $1,000,000. In retrospect that was a bad decision, but it would have been a good decision had interest rates fallen instead of moving
higher.
Other amounts needed for the journal entries under FASB 133 are derived below:
Bond
Interest
Rate Swap
Swap
Effect of
Change
Accural =
Swap Cash
Flow Minus
Amortization
07/01/00
09/30/00
12/31/00
03/31/01
06/30/01
09/30/01
12/31/01
03/31/02
06/30/02
Quarter
0
1
2
3
4
5
6
7
8
Principal
$10,000,000
$10,000,000
$10,000,000
$10,000,000
$10,000,000
$10,000,000
$10,000,000
$10,000,000
$10,000,000
Valuation
in Rates
of Basis
$0
$0
$0
$24,850
$52,100
$0
$73,800
$74,100
$350
$85,910
$38,334
$1,026
($42,820)
($100,405)
$1,175
($33,160)
$7,883
($723)
($21,850)
$6,629
($569)
$1,960
$16,191
($381)
$0
$8
$32
Small rounding error in the above calculations.
The journal entries corresponding to the above outcomes are shown below.
Debit
(Credit)
(10,000,000)
10,000,000
7/1/2000
Cash
Investments in bonds
-To record a fixed rate Bond payable
7/1/2000
Cash
0
Interest rate swaps receivable/payable
0
-This entry is not necessary in the real world since the swap had no cost.
Debit
(Credit)
(195,250)
195,250
9/30/2000
Interest expense/revenue
Cash
-To record bpnd interest received
9/30/2000
Cash
-To record interest swap receipt (payment)
(27,250)
27,250
9/30/2000

OCI adjusted for changes in the swap valuation
Loss (gain) on swap ineffectiveness
-To record change in Bond fair value
24,850
(24,850)
0
9/30/2000
Retained earnings
-To close expense and revenue accounts
(222,500)
222,500
0
Debit
(Credit)
(197,000)
197,000
12/31/2000
Cash
12/31/2000
Cash
(25,500)
25,500
12/31/2000

Accrued interest on swap
48,600
350
(48,950)
0
12/31/2000
Retained earnings
(222,500)
222,500
0
Debit
(Credit)
(195,250)
195,250
3/31/2001
Cash
3/31/2001
Cash
(27,250)
27,250
3/31/2001

11,434
676
(12,110)
0
3/31/2001
Retained earnings
-To close interest expense/revenue
(222,500)
222,500
0
6/30/2001
Cash
6/30/2001
Debit
(Credit)
(193,000)
193,000
(29,500)
Cash
29,500
6/30/2001

(128,879)
149
128,730
0
6/30/2001
Retained earnings
(222,500)
222,500
0
Debit
(Credit)
(225,000)
225,000
9/30/2001
Cash
9/30/2001
Cash
2,500
(2,500)
9/30/2001

11,557
(1,897)
(9,660)
0
9/30/2001
Retained earnings
(222,500)
222,500
0
Debit
(Credit)
(227,750)
227,750
12/31/2001
Cash
12/31/2001
Cash
5,250
(5,250)
12/31/2001

11,156
154
(11,310)

Retained earnings
(222,500)
222,500
0
12/31/2001
Debit
(Credit)
(230,500)
230,500
3/31/2002
Cash
3/31/2002
Cash
8,000
(8,000)
3/31/2002

23,622
188
(23,810)
0
3/31/2002
Retained earnings
(222,500)
222,500
0
Debit
(Credit)
(220,500)
220,500
6/30/2002
Cash
6/30/2002
Cash
(2,000)
2,000
6/30/2002

(2,373)
413
1,960
0
6/30/2002
Retained earnings
(222,500)
222,500
0

6/30/2002
Cash
-To record a proceeds of bond repayment.
10,000,000
(10,000,000)

Bond
Interest
Interest Rate
Swap
Bond
Proceeds
Applications of Cash
7/1/2000
Sources of Cash:
09/30/00
12/31/00
03/31/01
06/30/01
09/30/01
12/31/01
03/31/02
06/30/02
Bond
Investment
($10,000,000)
195,250
197,000
195,250
193,000
225,000
227,750
230,500
220,500
$1,684,250
27,250
25,500
27,250
29,500
(2,500)
(5,250)
(8,000)
2,000
10,000,000
$95,750
$10,000,000
$11,780,000
$1,780,000
Variable
Bond
Rate
0.019525
0.019525
0.019700
0.019525
0.019300
0.022500
0.022775
0.023050
0.022050
Bond &
Swap
Principal
10000000
10000000
10000000
10000000
10000000
10000000
10000000
10000000
10000000
LIBOR
Plus
2.2500%
7.8100%
7.8100%
7.8800%
7.8100%
7.7200%
9.0000%
9.1100%
9.2200%
8.8200%
Hedged
Annual
Return
9.0000%
9.0000%
9.0000%
9.0000%
9.0000%
9.0000%
9.0000%
9.0000%
9.0000%
Bond
Interest
Revenue
0
195250
197000
195250
193000
225000
227750
230500
220500
Net
Swap
Rate
0.000000
0.002725
0.002550
0.002725
0.002950
(0.000250)
(0.000525)
(0.000800)
0.000200
Interest
Swap
Revenue
0
27250
25500
27250
29500
(2500)
(5250)
(8000)
2000
Swap's
Estimated
Value
0
24850
73800
85910
(42820)
(33160)
(21850)
1960
0
341/speakers/133glosf.htm
million
$10
in
iable
ther
ot
ns that
FASB's
Ex Ante
Yield Curve
Rate
FASB's
Ex Ante
Yield Curve
Rate
FASB's
Ex Ante
Yield Curve
Rate
09/29/01
6.75%
6.86%
6.99%
7.11%
12/30/01
6.86%
6.97%
7.10%
03/30/02
6.97%
6.57%
06/30/02
6.52%
Ex Ante
Yield Curve
Rates
Ex Ante
Yield Curve
Rates
Ex Ante
Yield Curve
Rates
Ex Ante
Yield Curve
Rates
06/29/01
5.47%
6.75%
6.87%
6.98%
7.10%
($42,820)
09/29/01
6.75%
6.86%
6.99%
7.11%
($33,160)
12/30/01
6.86%
6.97%
7.10%
($21,850)
03/30/02
6.97%
6.57%
$1,960
06/30/02
6.52%
$0
Swap Rate
Minus
Spot Rate
0.2725%
0.2550%
0.2725%
0.2950%
-0.0250%
-0.0525%
-0.0800%
0.0200%
Interest Rate
Swap
Cash Flow
27,250
25,500
27,250
29,500
(2,500)
(5,250)
(8,000)
2,000
$95,750
There is slight rounding error below:

Interest
Bond
Bond
Rate Swap
Revenue
Revenue
Valuation
Unhedged
Hedged
24,850
195,250
222,500
73,800
197,000
222,500
85,910
195,250
222,500
(42,820)
193,000
222,500
(33,160)
225,000
222,500
(21,850)
227,750
222,500
1,960
230,500
222,500
0
220,500
222,500
=sum of net swap receipts
ess a firm wants to
hould the borrower elect

nging interest rates.
ase, a hedge that locks in

., $1,020,000) to pay off
rder to keep fair value

f $12,225 to keep the
n instead of moving
Interest Rate
Swap
Bond
Revenue
Interest
Rate Swap
Bond
Revenue
Actual
Bond
Cash Flow
$0
$27,250
$25,500
$27,250
$29,500
($2,500)
($5,250)
($8,000)
$2,000
Unhedged
$0
$195,250
$197,000
$195,250
$193,000
$225,000
$227,750
$230,500
$220,500
alculations.
Balance
(10,000,000)
10,000,000
(10,000,000)
0
Balance
(195,250)
(9,804,750)
9/30/2000
(222,500)
(9,777,500)
9/30/2000
24,850
(24,850)
0
9/30/2000
(222,500)
0
0
9/30/2000
Ineffectiveness
$0
$0
$0
$0
$0
$0
$0
$0
$0
Hedged
$0
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
Value
$10,000,000
$10,000,000
$10,000,000
$10,000,000
$10,000,000
$10,000,000
$10,000,000
$10,000,000
#REF!
Balance
(197,000)
(9,580,500)
12/31/2000
(222,500)
(9,555,000)
12/31/2000
73,450
350
(73,800)
0
12/31/2000
(222,500)
0
0
12/31/2000
Balance
(195,250)
(9,359,750)
3/31/2001
(222,500)
(9,332,500)
3/31/2001
84,884
1,026
(85,910)
0
3/31/2001
(222,500)
0
0
3/31/2001
Balance
(193,000)
(9,139,500)
6/30/2001
(222,500)
6/30/2001
(9,110,000)
(43,995)
1,175
42,820
0
6/30/2001
(222,500)
0
0
6/30/2001
Balance
(225,000)
(8,885,000)
9/30/2001
(222,500)
(8,887,500)
9/30/2001
(32,437)
(723)
33,160
0
9/30/2001
(222,500)
0
0
9/30/2001
Balance
(227,750)
(8,659,750)
12/31/2001
(222,500)
(8,665,000)
12/31/2001
(21,281)
(569)
21,850
12/31/2001
0
12/31/2001
(222,500)
0
0
Balance
(230,500)
(8,434,500)
3/31/2002
(222,500)
(8,442,500)
3/31/2002
2,341
(381)
(1,960)
0
3/31/2002
(222,500)
0
0
3/31/2002
Balance
(220,500)
(8,222,000)
6/30/2002
(222,500)
(8,220,000)
6/30/2002
(32)
32
0
0
6/30/2002
(222,500)
0
0
6/30/2002
1,780,000
0
6/30/2002
Example 5 Swap Value Calculation
Maturity
07/01/01
09/30/01
12/31/01
03/31/02
06/30/02
09/30/02
12/31/02
03/31/03
06/30/03
Totals
Accrued
Interest on
Swap
0
0
350
1026
1175
(723)
(569)
(381)
32
Maturity
07/01/01
09/30/01
12/31/01
03/31/02
06/30/02
09/30/02
12/31/02
03/31/03
06/30/03
Totals
07/01/01
Yield
Curve
5.56%
5.72%
5.88%
6.04%
6.20%
6.36%
6.52%
6.68%
09/30/01
Yield
Curve
5.56%
5.63%
5.78%
5.93%
6.07%
6.22%
6.37%
6.52%
Quarterly
Quarterly forward
yields
rates
1.390%
1.430%
1.470%
1.510%
1.550%
1.590%
1.630%
1.669%
Quarterly
yields
1.390%
1.408%
1.445%
1.482%
1.519%
1.556%
1.593%
1.630%
12/31/01
Maturity
07/01/01
09/30/01
12/31/01
03/31/02
06/30/02
09/30/02
12/31/02
03/31/03
06/30/03
Totals
Maturity
Yield
Curve
5.56%
5.63%
5.56%
5.68%
5.79%
5.91%
6.03%
6.14%
03/31/02
Yield
Curve
1.390%
1.470%
1.550%
1.630%
1.710%
1.789%
1.869%
1.949%
Quarterly
forward
rates
1.390%
1.408%
1.482%
1.556%
1.630%
1.704%
1.778%
1.852%
Swap
Receive
6.65% fixed
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
1.390%
1.408%
1.390%
1.419%
1.448%
1.477%
1.506%
1.536%
forward
rates
1.390%
1.408%
1.390%
1.448%
1.507%
1.565%
1.623%
1.681%
Quarterly
Quarterly forward
yields
rates
$139,000
$146,985
$154,972
$162,961
$170,951
$178,942
$186,936
$194,930
Swap
Receive
6.65% fixed
Pay
LIBOR
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
Quarterly
Quarterly
yields
Pay
LIBOR
$139,000
$140,750
$148,153
$155,557
$162,962
$170,369
$177,777
$185,187
Swap
Receive
6.65% fixed
$139,000
$140,750
$139,000
$144,825
$150,651
$156,478
$162,306
$168,135
Swap
Receive
6.65% fixed
$195,250
$203,235
$211,222
$219,211
$227,201
$235,192
$243,186
$251,180
Hedged
cash flow
LIBOR + 2.25%
$195,250
$197,000
$204,403
$211,807
$219,212
$226,619
$234,027
$241,437
Hedged
Pay
LIBOR
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
Hedged
cash flow
LIBOR + 2.25%
Pay
LIBOR
cash flow
LIBOR + 2.25%
$195,250
$197,000
$195,250
$201,075
$206,901
$212,728
$218,556
$224,385
Hedged
cash flow
LIBOR + 2.25%
07/01/01
09/30/01
12/31/01
03/31/02
06/30/02
09/30/02
12/31/02
03/31/03
06/30/03
Totals
Maturity
07/01/01
09/30/01
###
03/31/02
06/30/02
09/30/02
12/31/02
03/31/03
06/30/03
Totals
Maturity
07/01/01
09/30/01
12/31/01
03/31/02
06/30/02
09/30/02
12/31/02
03/31/03
06/30/03
Totals
Maturity
07/01/01
09/30/01
12/31/01
03/31/02
06/30/02
09/30/02
12/31/02
03/31/03
5.56%
5.63%
5.56%
5.47%
5.59%
5.70%
5.82%
5.94%
06/30/02
Yield
Curve
5.56%
5.63%
5.56%
5.47%
6.75%
6.87%
6.98%
7.10%
09/30/02
Yield
Curve
5.56%
5.63%
5.56%
5.47%
6.75%
6.86%
6.99%
7.11%
12/31/02
Yield
Curve
5.56%
5.63%
5.56%
5.47%
6.75%
6.86%
6.97%
1.390%
1.408%
1.390%
1.368%
1.397%
1.426%
1.456%
1.485%
Quarterly
yields
1.390%
1.408%
1.390%
1.368%
1.688%
1.717%
1.746%
1.776%
Quarterly
yields
1.390%
1.408%
1.390%
1.368%
1.688%
1.715%
1.746%
1.778%
Quarterly
yields
1.390%
1.408%
1.390%
1.368%
1.688%
1.715%
1.743%
1.390%
1.408%
1.390%
1.368%
1.426%
1.485%
1.544%
1.602%
Quarterly
forward
rates
1.390%
1.408%
1.390%
1.368%
1.688%
1.746%
1.805%
1.864%
Quarterly
forward
rates
1.390%
1.408%
1.390%
1.368%
1.688%
1.715%
1.778%
1.840%
Quarterly
forward
rates
1.390%
1.408%
1.390%
1.368%
1.688%
1.715%
1.743%
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
$139,000
$140,750
$139,000
$136,750
$142,620
$148,492
$154,364
$160,236
Swap
Receive
6.65% fixed
Pay
LIBOR
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
$139,000
$140,750
$139,000
$136,750
$168,750
$174,621
$180,493
$186,366
Swap
Receive
6.65% fixed
Pay
LIBOR
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
$139,000
$140,750
$139,000
$136,750
$168,750
$171,500
$177,768
$184,038
Swap
Receive
6.65% fixed
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
Pay
LIBOR
$139,000
$140,750
$139,000
$136,750
$168,750
$171,500
$174,250
$195,250
$197,000
$195,250
$193,000
$198,870
$204,742
$210,614
$216,486
Hedged
cash flow
LIBOR + 2.25%
$195,250
$197,000
$195,250
$193,000
$225,000
$230,871
$236,743
$242,616
Hedged
cash flow
LIBOR + 2.25%
$195,250
$197,000
$195,250
$193,000
$225,000
$227,750
$234,018
$240,288
Hedged
cash flow
LIBOR + 2.25%
$195,250
$197,000
$195,250
$193,000
$225,000
$227,750
$230,500
06/30/03
Totals
Maturity
07/01/01
09/30/01
12/31/01
03/31/02
06/30/02
09/30/02
12/31/02
03/31/03
06/30/03
Totals
7.10%
03/31/03
Yield
Curve
5.56%
5.63%
5.56%
5.47%
6.75%
6.86%
6.97%
6.57%
1.775%
1.807%
Quarterly
Quarterly forward
yields
rates
1.390%
1.408%
1.390%
1.368%
1.688%
1.715%
1.743%
1.643%
1.390%
1.408%
1.390%
1.368%
1.688%
1.715%
1.743%
1.643%
$166,250
$180,738
Swap
Receive
6.65% fixed
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
$166,250
$236,988
Hedged
cash flow
LIBOR + 2.25%
Pay
LIBOR
$139,000
$140,750
$139,000
$136,750
$168,750
$171,500
$174,250
$164,258
$195,250
$197,000
$195,250
$193,000
$225,000
$227,750
$230,500
$220,508
Acknowledgments
We want to acknowledge the help from two individuals who independently found a calculation error in our first round of calculations. Thanks g
to Peter van Amson from BankWare Inc and Dr. Walter R. Teets from Gonzaga University. Dr. Teets and his co-author, Robert Uhl, provide a free book
online at at http://www.gonzaga.edu/faculty/teets/index0.html
.
Peter van Amson sent us a corrected version of our own spreadsheet. He also recommended the following references:
For W.R.T. swaps the standard text used in practice is the Hull Book. Options, Futures and Other Derivatives, John C. Hull it has a fairly straigh
forward valuation of swaps. For an "advanced" actually just more mathematical treatment of the problem I recommend Interest Rate Option
Models, Ricardo Rebonato.
The Hull reference is as follows: John C. Hull,
Options, Futures, and Other Derivatives
The Rebonato referernce is as follows: Ricardo Rebonato,
Interest Rate Option Models
(Prentice-Hall, 1999,
ISBN: 0130224448)
(John Wiley & Sons, Wiley Finance, 1998, ISBN 0-47
Receive fixed/Pay variable

$10,000,000 Principal
6.65%
Net Effect
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
Net Effect
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
Swap
cash flow
$27,250
$19,265
$11,278
$3,289
$(4,701)
$(12,692)
$(20,686)
$(28,680)
$(5,677)
Swap
cash flow
$27,250
$25,500
$18,097
$10,693
$3,288
$(4,119)
$(11,527)
$(18,937)
$50,245
07/01/01
Swap
Value
$26,876
$18,725
$10,795
$3,098
$(4,353)
$(11,546)
$(18,473)
$(25,122)
$(0)
Quarters
remaining
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
0
Swap Value
09/30/01
Swap
Value
$$25,146
$17,586
$10,232
$3,095
$(3,813)
$(10,485)
$(16,911)
$24,850
t
1.00
2.00
3.00
4.00
5.00
6.00
7.00
0
= Sept. 30 Swap Value

12/31/2001
12/31/01
Net Effect
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
Swap
cash flow
$27,250
$25,500
$27,250
$21,425
$15,599
$9,772
$3,944
$(1,885)
$128,854
Swap
Value
$$$26,876
$20,829
$14,940
$9,215
$3,660
$(1,720)
$73,800
0.001165
= Dec 31 Swap Value

3/31/2002
Net Effect
Swap
cash flow
03/31/02
Swap
Value
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
Net Effect
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$27,250
$25,500
$27,250
$29,500
$23,630
$17,758
$11,886
$6,014
$168,788
Swap
cash flow
$27,250
$25,500
$27,250
$29,500
$(2,500)
$(8,371)
$(14,243)
$(20,116)
$64,270
$$$$29,102
$22,983
$17,020
$11,219
$5,586
$85,910
0.001174
= Mar 31 Swap Value
06/30/02
Swap
Value
$$$$$(2,459)
$(8,091)
$(13,522)
$(18,748)
$(42,820)
0.001174
#REF! Swap Value

9/30/2002
Net Effect
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
Swap
cash flow
$27,250
$25,500
$27,250
$29,500
$(2,500)
$(5,250)
$(11,518)
$(17,788)
$72,444
09/30/02
Swap
Value
$$$$$$(5,161)
$(11,126)
$(16,872)
$(33,160)
0.001254
9/30/2002 Swap Value

12/31/2002
Net Effect
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
Swap
cash flow
$27,250
$25,500
$27,250
$29,500
$(2,500)
$(5,250)
$(8,000)
12/31/02
Swap
Value
$$$$$$$(7,863)
$222,500
Net Effect
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$(14,488)
$79,262
Swap
cash flow
$27,250
$25,500
$27,250
$29,500
$(2,500)
$(5,250)
$(8,000)
$1,992
$95,742
our first round of calculations. Thanks go

o-author, Robert Uhl, provide a free book
rences:
vatives, John C. Hull it has a fairly straight

em I recommend Interest Rate Option
ll, 1999,
ISBN: 0130224448)
& Sons, Wiley Finance, 1998, ISBN 0-471-96569-3)
$(13,987)
$(21,850)
0.001297
12/31/2002 Swap Value
03/31/03
Swap
Value
$$$$$$$$1,960
$1,960
#REF! Swap Value
FVIF
1.0139
1.0288
1.0447
1.0618
1.0799
1.0992
1.1198
1.141624
1.0139
1.0147
1.0155
1.0163
1.0171
1.0179
1.0187
1.0195
1.141624
FVIF
1.0000
1.0141
1.0291
1.0451
1.0621
1.0802
1.0994
1.1198
FVIF
1.00
2.00
3.00
4.00
5.00
6.00
1.0000
1.0000
1.0139
1.0286
1.0441
1.0604
1.0776
1.0957
FVIF
1.00
2.00
3.00
4.00
5.00
1.0000
1.0000
1.0000
1.0137
1.0281
1.0434
1.0595
1.0765
FVIF
1.00
2.00
3.00
4.00
1.0000
1.0000
1.0000
1.0000
1.0169
1.0346
1.0533
1.0729
FVIF
1.00
2.00
3.00
1.0000
1.0000
1.0000
1.0000
1.0000
1.0172
1.0352
1.0543
FVIF
1.00
1.0000
1.0000
1.0000
1.0000
1.0000
1.0000
1.0174
2.00
1.0358
FVIF
1.00
1.0000
1.0000
1.0000
1.0000
1.0000
1.0000
1.0000
1.0164
The FASB's Original Accounting of the Interest Rate Swap in FAS 133
Example 5 on Page 75
Swap
OCI
Earnings
Cash
LIBOR
Debit (Credit) Debit (Credit) Debit (Credit) Debit (Credit)
5.56% 7/1/X1
$-
5.63%
Interest accrued
Payment (Receipt)
Effect of change in rates
Reclassification to earnings
9/30/X1
$(27,250)
52,100
24,850
Interest accrued
Payment (Receipt)
$330
(25,500)
74,120
-
27,250
(52,100)
27,250
(24,850)
(27,250)
(27,250)
27,250
(330)
25,500
(74,120)
25,500
(25,500)
In my judgment, the FASB made calculation errors for Interest Accrued each quarter.
Bob Jensen's Recalculation and Correction of the Interest Rate Swap in FAS 133
Example 5 on Page 75
Swap
OCI
Earnings
Cash
LIBOR
Debit (Credit) Debit (Credit) Debit (Credit) Debit (Credit)
5.56% 7/1/X1
$Interest accrued
Payment (Receipt)
5.63% 9/30/X1
$(27,250)
52,100
24,850
Interest accrued
Payment (Receipt)
5.56% 12/31/X1
$350
(25,500)
74,100
73,800
Interest accrued
Payment (Receipt)
5.47% 3/31/X2
$1,026
(27,250)
38,334
85,910
Interest accrued
Payment (Receipt)
6.75% 6/30/X2
$1,175
(29,500)
(100,405)
(42,820)
Interest accrued
Payment (Receipt)
6.86% 9/30/X2
$(723)
2,500
7,883
(33,160)
Interest accrued
Payment (Receipt)
6.97% 12/31/X2
$(569)
5,250
6,629
(21,850)
Interest accrued
Payment (Receipt)
6.57% 3/31/X3
$(381)
8,000
16,191
1,960
27,250
(52,100)
27,250
(24,850)
(27,250)
(27,250)
27,250
(350)
25,500
(74,100)
25,500
(73,800)
(25,500)
(25,500)
25,500
(1,026)
27,250
(38,334)
27,250
(85,910)
(27,250)
(27,250)
27,250
(1,175)
29,500
100,405
29,500
42,820
(29,500)
(29,500)
29,500
723
(2,500)
(7,883)
(2,500)
33,160
2,500
2,500
(2,500)
569
(5,250)
(6,629)
(5,250)
21,850
5,250
5,250
(5,250)
381
(8,000)
(16,191)
(8,000)
(1,960)
8,000
8,000
(8,000)
Interest accrued
Payment (Receipt)
Rounding error
6/30/X3
$32
(2,000)
8
-
(32)
2,000
(8)
2,000
-
(2,000)
(2,000)
2,000
Analysis Allowing for Hedge Ineffectiveness


Annual
LIBOR
LIBOR
Plus
Quarter
Rate
2.2500%
0
5.5600%
7.8100%
1
5.5600%
7.8100%
2
5.6300%
7.8800%
3
5.5600%
7.8100%
4
5.4700%
7.7200%
5
6.7500%
9.0000%
6
6.8600%
9.1100%
7
6.9700%
9.2200%
8
6.5700%
8.8200%
Annual
Swap
Rate
6.6500%
6.6500%
6.6500%
6.6500%
6.6500%
6.6500%
6.6500%
6.6500%
6.6500%
Quarter
07/01/01
09/30/01
12/31/01
03/31/02
06/30/02
09/30/02
12/31/02
03/31/03
06/30/03
Note
Payoff
Bond
Proceeds

Bond
Interest
Interest Rate
Swap
Sources of Cash:
7/1/2001
Applications of Cash:
07/01/01
09/30/01
12/31/01
03/31/02
06/30/02
09/30/02
12/31/02
03/31/03
06/30/03
($10,000,000)
195,250
197,000
195,250
193,000
225,000
227,750
230,500
220,500
$1,684,250
27,250
25,500
27,250
29,500
(2,500)
(5,250)
(8,000)
2,000
$95,750
10,000,000
$10,000,000
$11,780,000
Quarterly
LIBOR
Rate
0.013900
0.013900
0.014075
0.013900
0.013675
0.016875
0.017150
0.017425
0.016425
Net decrease in cash =
$1,780,000
Scroll down slowly and try to follow the logic of a fair value hedge.
A glossary of FAS 133 terminology is available at
The Example 5 swap cash flows and swap valuations on Page 75 of FAS 133 are totally inconsistent with an alternate way of computing swap
valuations as proposed by Jarrow and Turnbull. See
http://www.trinity.edu/rjensen/caseans/133ex05jt.htm
. In this spreadsheet, we will refer
to the swap valuation approach given in Derivative Securities, Second Edition, by Robert Jarrow and Stuart Turnbull (South-Western College
Publishing, 2000, ISBN 0-538-87740-5). The swap valuation section begins on Page 434 and is illustrated on Page 435.
In Example 5 of FAS 133 on Page 75, the FASB admittedly did not provide yield (swap) curve values or their corresponding B(0,T)
discounting factors. For instance, suppose R(0,T) depicts the discount rate taken from a yield (swap) curve for time T. Consider the $24,850
swap valuation given by the FASB in Page 75 of FAS 133 for September 30, 20X1. This is derived in theory as follows using the $27,250
swap cash flows for t=1,,7 for T=7 quarters December 31, 20X1 thru March 31, 20X3:
$24,850 = ($27,250)/(1+R(0,T))
= ($27,250)(1+B(0,T))
In practice, the B(0,T) swap valuation discount factors are derived from yield (swap) curves derived by financial services such as Bloomberg
at http://www.bloomberg.com/ . You can read more about such matters under the definition of Yield Curve in
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#Y-Terms
By way of illustration, suppose the quarterly rate yield curve is as follows:

Ex Ante
Yield Curve
Amount
Yield Curve
Present Value
1.3900%
1.4075%
1.4446%
1.4817%
1.5188%
1.5559%
1.5930%
$1
$1
$1
$1
$1
$1
$1
0.986291
0.972433
0.957885
0.942864
0.927401
0.911526
0.895269
The above discount factors yield the following swap value:
$179,677 =
=
($27,250)/(1+R(0,T))
($27,250)(1+B(0,T))
$179,677 =
=
($27,250)/(1+R(0,T))
($27,250)(1+B(0,T))
In the following table, the blue amounts asuumed in Example 5 beginning in Paragraph 131 of FAS 133
are filled in the cells. Students may, however, replace the following values with other numbers to study
the sensitivity of the outcomes to the input values.
In this illustration, we will assume that there is no hedge ineffectiveness.
To better understand the yield (swap) curve factors, you may want to read the spreadsheet in
this workbook entitled "Yield Curve." For example, in that spreadsheet the following factors
are derived for the first swap fair value adjustment on September 30:
Date
07/01/01
09/30/01
12/31/01
03/31/02
06/30/02
09/30/02
12/31/02
03/31/03
06/30/03
Actual
Bond
Rates
Flat
Yield Curve
Factor
Flat
Yield Curve
Factor
Flat
Yield Curve
Factor
Flat
Yield Curve
Factor
7.8100%
7.8800%
7.8100%
7.7200%
9.0000%
9.1100%
9.2200%
8.8200%
9/30/2001
0.986291
0.972433
0.957885
0.942864
0.927401
0.911526
0.895269
12/31/2001
0.986120
0.972769
0.958607
0.944110
0.929300
0.914197
3/31/2002
0.986291
0.973201
0.959240
0.944934
0.930304
6/30/2002
0.986509
0.967085
0.950211
0.933092
Summary of Input to the Effectiveness Case Solution

You may change the values shown below in blue in order to test the sensitivity of the
Effectiveness Solution outcomes. In particular, you should compare patterns yield curve
factors.
Actual
Optional
Optional
Optional
APR Rate
Bond
Yield Curve
Yield Curve
Yield Curve
Date
Spot
Rates
Factors
Factors
Factors
07/01/01
0.0556
09/30/01
0.0556
7.8100%
9/30/2001
12/31/01
0.0563
7.8800%
0.986291
12/31/2001
03/31/02
0.0556
7.8100%
0.972433
0.986120
3/31/2002
06/30/02
0.0547
7.7200%
0.957885
0.972769
0.986291
09/30/02
0.0675
9.0000%
0.942864
0.958607
0.973201
12/31/02
0.0686
9.1100%
0.927401
0.944110
0.959240
03/31/03
0.0697
9.2200%
0.911526
0.929300
0.944934
06/30/03
0.0657
8.8200%
0.895269
0.914197
0.930304
Sum =
6.593670
5.705104
4.793970
The swap outcomes are shown below:

Date
09/30/01
12/31/01
03/31/02
06/30/02
09/30/02
12/31/02
03/31/03
06/30/03
Fixed
Swap
Rate
6.65%
6.65%
6.65%
6.65%
6.65%
6.65%
6.65%
6.65%
Actual
Bond
Rates
7.81%
7.88%
7.81%
7.72%
9.00%
9.11%
9.22%
8.82%
Quarterly
Swap
Rate
1.6625%
1.6625%
1.6625%
1.6625%
1.6625%
1.6625%
1.6625%
1.6625%
Quarterly
LIBOR Spot
Rate
1.3900%
1.4075%
1.3900%
1.3675%
1.6875%
1.7150%
1.7425%
1.6425%
Spot Rate
Relative to
July 1 Rate
100.0000%
101.2590%
100.0000%
98.3813%
121.4029%
123.3813%
125.3597%
118.1655%
The actual note values are compared with the estimated values below:
Other amounts needed for the journal entries under FASB 133 are derived below:
07/01/01
09/30/01
12/31/01
03/31/02
06/30/02
09/30/02
12/31/02
03/31/03
06/30/03
Quarter
0
1
2
3
4
5
6
7
8
Bond
Principal
$10,000,000
$10,000,000
$10,000,000
$10,000,000
$10,000,000
$10,000,000
$10,000,000
$10,000,000
$10,000,000
Accural =
Interest
Swap Cash
Rate Swap
Effect of
Flow Minus
Swap
Change
Amortization
Valuation
in Rates
of Basis
$0
$0
$0
$180,572
$207,822
$0
$145,737
($11,876)
$2,542
$130,748
$10,235
$2,026
$114,074
$11,038
$1,788
($7,254)
($125,752)
$1,925
($10,236)
($8,108)
($124)
($7,863)
($5,449)
($178)
$0
$9,992
($129)
Small rounding error in the above calculations.
The journal entries corresponding to the above outcomes are shown below.
7/1/2001
Cash
-To record a fixed rate Bond payable
Debit
(Credit)
(10,000,000)
10,000,000
9/30/2001
Cash
0
0
-This entry is not necessary in the real world since the swap had no cost.
Debit
(Credit)
(195,250)
195,250
9/30/2001
Cash
-To record bond interest payment
9/30/2001
Cash
(27,250)
27,250
9/30/2001

180,572
(180,572)
0
9/30/2001
Retained earnings
(222,500)
222,500
0
Debit
(Credit)
(197,000)
197,000
12/31/2001
Cash
12/31/2001
Cash
(25,500)
25,500
12/31/2001

(34,835)
34,835
0
12/31/2001
Retained earnings
(222,500)
222,500
0
Debit
(Credit)
3/31/2002
Cash
(195,250)
195,250
3/31/2002
Cash
(27,250)
27,250
3/31/2002

(14,989)
14,989
0
3/31/2002
Retained earnings
(222,500)
222,500
0
Debit
(Credit)
(193,000)
193,000
6/30/2002
Cash
6/30/2002
Cash
(29,500)
29,500
6/30/2002

(16,674)
16,674
0
6/30/2002
Retained earnings
(222,500)
222,500
0
9/30/2002
Cash
9/30/2002
Cash
Debit
(Credit)
(225,000)
225,000
2,500
(2,500)
9/30/2002

(121,327)
121,327
0
9/30/2002
Retained earnings
(222,500)
222,500
0
Debit
(Credit)
(227,750)
227,750
12/31/2002
Cash
12/31/2002
Cash
5,250
(5,250)
12/31/2002

(2,982)
2,982
0
12/31/2002
Retained earnings
(222,500)
222,500
0
Debit
(Credit)
(230,500)
230,500
3/31/2003
Cash
3/31/2003
Cash
8,000
(8,000)
3/31/2003

2,373
(2,373)
0
3/31/2003
Retained earnings
(222,500)
222,500
0
Debit
(Credit)
(220,500)
220,500
6/30/2003
Cash
6/30/2003
Cash
(2,000)
2,000
6/30/2003

7,863
(7,863)
0
6/30/2003
Retained earnings
6/30/2003
Cash
-To record a proceeds of bond repayment.
(222,500)
222,500
0
10,000,000
(10,000,000)

Bond
Interest
Interest Rate
Swap
Bond
Proceeds
Applications of Cash
7/1/2001
Sources of Cash:
09/30/01
12/31/01
03/31/02
06/30/02
09/30/02
12/31/02
03/31/03
06/30/03
Bond
Investment
($10,000,000)
195,250
197,000
195,250
193,000
225,000
227,750
230,500
220,500
$1,684,250
27,250
25,500
27,250
29,500
(2,500)
(5,250)
(8,000)
2,000
10,000,000
$95,750
$10,000,000
$11,780,000
$1,780,000
Variable
Bond
Rate
0.019525
0.019525
0.019700
0.019525
0.019300
0.022500
0.022775
0.023050
0.022050
Bond &
Swap
Principal
10000000
10000000
10000000
10000000
10000000
10000000
10000000
10000000
10000000
LIBOR
Plus
2.2500%
7.8100%
7.8100%
7.8800%
7.8100%
7.7200%
9.0000%
9.1100%
9.2200%
8.8200%
Hedged
Annual
Return
9.0000%
9.0000%
9.0000%
9.0000%
9.0000%
9.0000%
9.0000%
9.0000%
9.0000%
Bond
Interest
Revenue
0
195250
197000
195250
193000
225000
227750
230500
220500
Net
Swap
Rate
0.000000
0.002725
0.002550
0.002725
0.002950
(0.000250)
(0.000525)
(0.000800)
0.000200
Interest
Swap
Revenue
0
27250
25500
27250
29500
(2500)
(5250)
(8000)
2000
Swap's
Estimated
Value
0
24850
73800
85910
(42820)
(33160)
(21850)
1960
0
Hedged Versus Unhedged Yields

12
10
8
6
4
2
0
341/speakers/133glosf.htm
mputing swap
preadsheet, we will refer
stern College
,T)
the $24,850
e $27,250
Bloomberg
Flat
Yield Curve
Factor
Flat
Yield Curve
Factor
Flat
Yield Curve
Factor
9/30/2002
0.983405
0.966563
0.949386
3/31/2003
0.966563
0.949495
6/30/2003
0.982873
Optional
Yield Curve
Factors
Optional
Yield Curve
Factors
Optional
Yield Curve
Factors
6/30/2002
0.986509
0.967085
0.950211
0.933092
3.836898
9/30/2002
0.983405
0.966563
0.949386
2.899354
3/31/2003
0.966563
0.949495
1.916058
6/30/2003
0.982873
0.982873
Swap Rate
Minus
Spot Rate
0.2725%
0.2550%
0.2725%
0.2950%
-0.0250%
-0.0525%
-0.0800%
0.0200%
Interest Rate
Swap
Cash Flow
27,250
25,500
27,250
29,500
(2,500)
(5,250)
(8,000)
2,000
$95,750
There is slight rounding error below:

Interest
Bond
Bond
Rate Swap
Revenue
Revenue
Valuation
Unhedged
Hedged
180,572
195,250
222,500
145,737
197,000
222,500
130,748
195,250
222,500
114,074
193,000
222,500
(7,254)
225,000
222,500
(10,236)
227,750
222,500
(7,863)
230,500
222,500
0
220,500
222,500
=sum of net swap payments
Quarterly R
12
10
8
6
4
2
0
Interest Rate
Swap
Cash Flow
$0
$27,250
$25,500
$27,250
$29,500
($2,500)
($5,250)
($8,000)
$2,000
alculations.
Balance
(10,000,000)
10,000,000
Bond
Revenue
Unhedged
$0
$195,250
$197,000
$195,250
$193,000
$225,000
$227,750
$230,500
$220,500
Interest
Rate Swap
Ineffectiveness
$0
$0
$0
$0
$0
$0
$0
$0
$0
Bond
Revenue
Hedged
$0
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
$222,500
Actual
Bond
Value
$10,000,000
$10,000,000
$10,000,000
$10,000,000
$10,000,000
$10,000,000
$10,000,000
$10,000,000
#REF!
(10,000,000)
0
Balance
(195,250)
(9,804,750)
9/30/2001
(222,500)
(9,777,500)
9/30/2001
180,572
(180,572)
0
9/30/2001
(222,500)
0
0
9/30/2001
Balance
(197,000)
(9,580,500)
12/31/2001
(222,500)
(9,555,000)
12/31/2001
145,737
(145,737)
0
12/31/2001
(222,500)
0
0
12/31/2001
Balance
(195,250)
(9,359,750)
3/31/2002
(222,500)
(9,332,500)
3/31/2002
130,748
(130,748)
0
3/31/2002
(222,500)
0
0
3/31/2002
Balance
(193,000)
(9,139,500)
6/30/2002
(222,500)
(9,110,000)
6/30/2002
114,074
(114,074)
0
6/30/2002
(222,500)
0
0
6/30/2002
Balance
(225,000)
(8,885,000)
(222,500)
(8,887,500)
9/30/2002
9/30/2002
(7,254)
7,254
0
9/30/2002
(222,500)
0
0
9/30/2002
Balance
(227,750)
(8,659,750)
12/31/2002
(222,500)
(8,665,000)
12/31/2002
(10,236)
10,236
0
12/31/2002
12/31/2002
(222,500)
0
0
Balance
(230,500)
(8,434,500)
3/31/2003
(222,500)
(8,442,500)
3/31/2003
(7,863)
7,863
0
3/31/2003
(222,500)
0
0
3/31/2003
Balance
(220,500)
(8,222,000)
6/30/2003
(222,500)
(8,220,000)
6/30/2003
0
0
0
6/30/2003
(222,500)
0
0
6/30/2003
1,780,000
0
6/30/2003
Quarterly Rates in Example 2

12
10
8
6
4
2
0
Derivation of Yield Curve Factors Using the Jarrow and Turnbull Approach

Annual
LIBOR
Annual
LIBOR
Plus
Swap
Quarter
Rate
2.2500%
Rate
0
5.5600%
7.8100%
6.6500%
1
5.5600%
7.8100%
6.6500%
2
5.6300%
7.8800%
6.6500%
3
5.5600%
7.8100%
6.6500%
4
5.4700%
7.7200%
6.6500%
5
6.7500%
9.0000%
6.6500%
6
6.8600%
9.1100%
6.6500%
7
6.9700%
9.2200%
6.6500%
8
6.5700%
8.8200%
6.6500%
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
Quarter
7/1/2001
9/30/2001
12/31/2001
3/31/2002
6/30/2002
9/30/2002
12/31/2002
3/31/2003
6/30/2003
Quarterly
LIBOR
Rate
0.013900
0.013900
0.014075
0.013900
0.013675
0.016875
0.017150
0.017425
0.016425
Variable
Bond
Rate
0.019525
0.019525
0.019700
0.019525
0.019300
0.022500
0.022775
0.023050
0.022050
= Question Number
What are yield curves and swap curves?
The following definition appears in my FAS 133 Glossary at
the graphical relationship between yield and time of maturity of debt or investments in financial instruments. In the case of interest rate
swaps, yield curves are also called swaps curves. Forward yield (or swaps) curves are used to value many types of derivative financial
instruments. If time is plotted on the abscissa, the yield is usually upward sloping due to term structure of interest rates. Term structure
is an empirically observed phenomenon that yields vary with dates to maturity.
FAS 133 refers to yield curves at various points such as in Paragraphs 112 and 319. They are also referred to by analogy at various
points such as in Paragraphs 162 and 428. Financial service firms obtain yield curves by plotting the yields of default-free coupon
bonds in a given currency against maturity or duration. Yields on debt instruments of lower quality are expressed in terms of a spread
relative to the default-free yield curve.
Paragraph 112 of SFAS 113 refers to the "zero-coupon method." This method is based upon
the term structure of spot default-free zero coupon rates. The interest rate for a specific forward period calculated from the incremental
period return in adjacent instruments. A very interesting web site on swaps curves is at
http://www.clev.frb.org/research/JAN96ET/yiecur.htm#1b
In practice, investors and auditors often rely upon the Bloomberg swaps curve estimations.
The contact information for Bloomberg
Financial Services is as follows: Bloomberg Financial Markets, 499 Park Avenue, New York, NY 10022; Telephone: 212-318-2000;
Fax: 212-980-4585; E-Mail: feedback@bloomberg.com; WWW Link: <
http://www.bloomberg.com/ > and
<http://www.wsdinc.com/pgs_www/w5594.shtml
>. Various pricing services are available such as Anderson Investors Software at
http://www.wsdinc.com/products/p3430.shtml
Cutter & Co. provides some illustrations yield curves at
http://www.stocktrader.com/summary.html
. Discussion group messages about yield curves are archived at
http://csf.colorado.edu/mail/longwaves/current-discussion/0086.html
.
http://www.clev.frb.org/research/JAN96ET/yiecur.htm#1b
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
In practice, investors and auditors often rely upon the Bloomberg swaps curve estimations.
The contact information for Bloomberg
Financial Services is as follows: Bloomberg Financial Markets, 499 Park Avenue, New York, NY 10022; Telephone: 212-318-2000;
Fax: 212-980-4585; E-Mail: feedback@bloomberg.com; WWW Link: <
http://www.bloomberg.com/ > and
<http://www.wsdinc.com/pgs_www/w5594.shtml
>. Various pricing services are available such as Anderson Investors Software at
http://www.wsdinc.com/products/p3430.shtml
Cutter & Co. provides some illustrations yield curves at
http://www.stocktrader.com/summary.html
. Discussion group messages about yield curves are archived at
http://csf.colorado.edu/mail/longwaves/current-discussion/0086.html
.
2
2
2
= Question Number
What is the yield curve for the note's FMV on 9/30/x1 at the end of Quarter 1?
At the end of Quarter 1, there are 8-1=7 quarters remaining. In Example 5, the
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
FASB does not provide the Time 1 present values for the seven quarters. These
present values or their equivalent yields to maturity are needed to derive the yield
curve for Quarter 1. In fact, there are an infinite number of possible yield curves
that can be used to derive the amortizations given in the FASB's solution to
Example 5 in SFAS 133.
3
3
3
3
= Question Number
How are interest rate swaps valued in practice? Illustrate this using the explanation
found in Edition 2 of Derivative Securities by Robert Jarrow and Stuart Trumbull
(Southwestern College Publishing, 2000, pp. 434-439.) Try to derive the
The Quarter 1 change in swap value is ($1,149) with a $156 Quarter 2 amortizaton in
the Example 5 solution provided by the FASB. Ceteris-paribus, seven payments
of $156 must accumulate to ($1,149). The interest rate that will allow payments of
$156 to accumulate to this value can be computed from Excel'a RATE function. If
the rate is known, however, Excel's PMT function can be used to computer the
amortization amount. These calculations for Quarter 2 are as follows:
$157.53
1.368%
($1,045)
($1,149)
= amortization of the change in FMV for the next seven quarters.

= quarterly rate for $156.34 to accumulate to ($1,149)
= present value of $156.34 for seven periods at the 1.62% quarterly rate
= future value of $156.34 for seven periods at the 1.62% quarterly rate
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
FAS 133 Example 5 swap valuations (see Page 75 FAS 133).

Page 75
Interest Rate
Swap
Cash Flow
0
27250
25500
27250
29500
(2500)
(5250)
(8000)
Sum =
$93,750
Eample 2
XYZ Corporation
Date
7/1/2001
9/30/2001
12/31/2001
3/31/2002
6/30/2002
9/30/2002
12/31/2002
3/31/2003
Page 75
Interest
Rate Swap
Valuation
0
24850
73800
85910
(42820)
(33160)
(21850)
1960
XYZ Corporation
Swap
Receivable/
(Payable)
0
24850
73800
85910
(42820)
(33160)
(21850)
1960
Answers are shown below:

3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
Consider the following calculations for the $27,250 swap cash flow on September 30:
Date
Swap Rate
LIBOR
09/30/01
Quarterly
Days
6.650%
1.6625%
5.560%
1.3900%
Difference =
0.2725%
91
APR Difference
1.0900%
91/365
Swap Payment = ($10,000,000)(.00007)(91/365) using the equation on Page 434 of Jarrow and Turnbull (20
Swap Payment =
based on 91/365 factor
$27,175
Swap Payment =
based on 90/360 factor
$27,250
The FASB does not provide the yield curve of treasury bill or Eurodollar deposits. However,
in Example 5, the FASB does state that the yield curve is upward sloping. Consider the following
alternative yield curves:
0
1
2
3
4
5
6
7
0
1
7/1/2001
9/30/2001
12/31/2001
3/31/2002
6/30/2002
9/30/2002
12/31/2002
3/31/2003
7/1/2001
9/30/2001
Ex Ante
Yield Curve
Amount
Yield Curve
Present Value
1.3900%
1.4075%
1.4446%
1.4817%
1.5188%
1.5559%
1.5930%
$1
$1
$1
$1
$1
$1
$1
0.986291
0.972433
0.957885
0.942864
0.927401
0.911526
0.895269
Ex Ante
Yield Curve
Amount
Yield Curve
Present Value
Estimated
Swap Payment
$27,250
$27,250
$27,250
$27,250
$27,250
$27,250
$27,250
Sum =
Estimated
Swap Payment
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
2
3
4
5
6
7
0
1
2
3
4
5
6
7
0
1
2
3
4
5
6
7
0
1
2
3
4
5
6
7
12/31/2001
3/31/2002
6/30/2002
9/30/2002
12/31/2002
3/31/2003
7/1/2001
9/30/2001
12/31/2001
3/31/2002
6/30/2002
9/30/2002
12/31/2002
3/31/2003
7/1/2001
9/30/2001
12/31/2001
3/31/2002
6/30/2002
9/30/2002
12/31/2002
3/31/2003
7/1/2001
9/30/2001
12/31/2001
3/31/2002
6/30/2002
9/30/2002
12/31/2002
3/31/2003
1.4075%
1.3900%
1.4191%
1.4482%
1.4773%
1.5064%
$1
$1
$1
$1
$1
$1
0.986120
0.972769
0.958607
0.944110
0.929300
0.914197
Ex Ante
Yield Curve
Amount
Yield Curve
Present Value
1.3900%
1.3675%
1.3968%
1.4261%
1.4554%
$1
$1
$1
$1
$1
0.986291
0.973201
0.959240
0.944934
0.930304
Ex Ante
Yield Curve
Amount
Yield Curve
Present Value
1.3675%
1.6875%
1.7169%
1.7464%
$1
$1
$1
$1
0.986509
0.967085
0.950211
0.933092
Ex Ante
Yield Curve
Amount
Yield Curve
Present Value
1.6875%
1.7150%
1.7464%
$1
$1
$1
0.983405
0.966563
0.949386
$25,500
$25,500
$25,500
$25,500
$25,500
$25,500
Sum =
Estimated
Swap Payment
$27,250
$27,250
$27,250
$27,250
$27,250
Sum =
Estimated
Swap Payment
$29,500
$29,500
$29,500
$29,500
Sum =
Estimated
Swap Payment
($2,500)
($2,500)
($2,500)
Sum =
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
0
1
2
3
4
5
6
7
0
1
2
3
4
5
6
7
7/1/2001
9/30/2001
12/31/2001
3/31/2002
6/30/2002
9/30/2002
12/31/2002
3/31/2003
7/1/2001
9/30/2001
12/31/2001
3/31/2002
6/30/2002
9/30/2002
12/31/2002
3/31/2003
Ex Ante
Yield Curve
Amount
Yield Curve
Present Value
1.7150%
1.7425%
$1
$1
0.966563
0.949495
Ex Ante
Yield Curve
Amount
Yield Curve
Present Value
1.7425%
$1
0.982873
Estimated
Swap Payment
($5,250)
($5,250)
Sum =
Estimated
Swap Payment
($8,000)
Sum =
sf.htm
nterest rate
financial
m structure
arious
upon
a spread
based upon
cremental
n for Bloomberg
8-2000;
oftware at
(It appears that this approach is not appropriate.)
Bond &
Swap
Principal
10000000
10000000
10000000
10000000
10000000
10000000
10000000
10000000
10000000
Bond
Interest
Revenue
0
195250
197000
195250
193000
225000
227750
230500
220500
Net
Interest
Swap's
Swap
Swap
Estimated
Rate
Revenue
Value
0.000000
0
0
0.002725
27250
24850
0.002550
25500
73800
0.002725
27250
85910
0.002950
29500
(42820)
(0.000250) (2500)
(33160)
(0.000525) (5250)
(21850)
(0.000800) (8000)
1960
0.000200
2000
0
n for Bloomberg
8-2000;
oftware at
34 of Jarrow and Turnbull (2000)
Estimated
Swap
Value on
9/30/2001
$26,876
$26,499
$26,102
$25,693
$25,272
$24,839
$24,396
$179,677
Estimated
Swap
Value on
12/31/2001
$25,146
$24,806
$24,444
$24,075
$23,697
$23,312
$145,480
Estimated
Swap
Value on
3/31/2002
$26,876
$26,520
$26,139
$25,749
$25,351
$130,636
Estimated
Swap
Value on
6/30/2002
$29,102
$28,529
$28,031
$27,526
$113,188
Estimated
Swap
Value on
9/30/2002
($2,459)
($2,416)
($2,373)
($7,248)
Estimated
Swap
Value on
12/31/2002
($5,074)
($4,985)
($10,059)
Estimated
Swap
Value on
3/31/2003
($7,863)
($7,863)

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Warning: This file is best viewed in Excel software rather than in a web browser.

Bob Jensen's web site is at http://www.trinity.edu/~rjensen

Questions This is Bob Jensen's answer file.

wap Revenue % of Total

ets in this Excel workbook.

Analysis Assuming a Perfect Hedge With No Ineffectiveness

Paragraph 137 Data of SFAS 133 (No ineffectiveness)

Summary of Cash Transactions

LIBOR Plus 2.2500%

Net increase in cash =

the sensitivity of the outcomes to the input values.

Summary of Input to the Effectiveness Case Solution

The swap outcomes are shown below:

Interest rate swaps receivable/payable

Interest rate swaps receivable/payable

Interest rate swaps receivable/payable

Interest rate swaps receivable/payable

Interest rate swaps receivable/payable

Interest rate swaps receivable/payable

Loss (gain) on swap ineffectiveness

Interest rate swaps receivable/payable

Interest rate swaps receivable/payable

-To close interest expense/revenue

Summary of Cash Transactions

There is slight rounding error below:

ess a firm wants to

hould the borrower elect

ase, a hedge that locks in

rder to keep fair value

Example 5 Swap Value Calculation

Options, Futures, and Other Derivatives

The Rebonato referernce is as follows: Ricardo Rebonato,

Interest Rate Option Models

(John Wiley & Sons, Wiley Finance, 1998, ISBN 0-47

Receive fixed/Pay variable

= Sept. 30 Swap Value

= Dec 31 Swap Value

= Mar 31 Swap Value

#REF! Swap Value

9/30/2002 Swap Value

our first round of calculations. Thanks go

vatives, John C. Hull it has a fairly straight

& Sons, Wiley Finance, 1998, ISBN 0-471-96569-3)

12/31/2002 Swap Value

#REF! Swap Value

Analysis Allowing for Hedge Ineffectiveness

Paragraph 137 Data of SFAS 133 (No ineffectiveness)

Summary of Cash Transactions

Net decrease in cash =

By way of illustration, suppose the quarterly rate yield curve is as follows:

The above discount factors yield the following swap value:

Summary of Input to the Effectiveness Case Solution

The swap outcomes are shown below:

Interest rate swaps receivable/payable

Interest rate swaps receivable/payable

Interest rate swaps receivable/payable

Interest rate swaps receivable/payable

Interest rate swaps receivable/payable

Interest rate swaps receivable/payable

Interest rate swaps receivable/payable

-To close interest expense/revenue

Interest rate swaps receivable/payable

Summary of Cash Transactions

Hedged Versus Unhedged Yields