Fair value hedge of changes in the benchmark interest rate for a variable-rate debt obligation Example fair value hedge
On January 1, Year 1 ABC Corp. issues a floating-rate non-amortizing debt instrument with a maturity of two years. The variable-rate liability resets every six months at the six-month LIBOR rate.
The six-month LIBOR rate on January 1, Year 1 is 2.5%. Example fair value hedge
At the same time, ABC enters into a six-month interest rate swap agreement with a notional amount equal to the face amount of the debt instrument. Under the terms of the swap agreement, ABC will receive the six-month LIBOR rate and pay the one-month LIBOR rate (for example 2.3%).
ABC wants to designate the interest rate swap as a fair value hedge of changes in fair value of the variable-rate debt obligation attributable to changes in the benchmark interest rate.
The variable-rate debt obligation has fair value exposure due to changes in interest rates during the six-month period between LIBOR reset dates (e.g. January 1, Year 1 to June 30, Year 1), even though the obligation would be at fair value (due to changes in interest rates) on each reset date. Therefore, the hedged risk could be the changes in fair value of the debt instrument due to the six-month fixed nature of the LIBOR-based interest rate. ABC could hedge the fixed six-month LIBOR rate (i.e. 2.5%) interest payments with a partial-term hedge that ends on June 30, Year 1.
Fair value hedge of an asset – Hedge fair value risk of an asset Examples fair value hedge
Hedger Co. has an asset with a current fair value of € 2,000 and the management is concerned that the fair value of the hedge will go down to € 1,900. This will result a loss to the company.
To offset this loss, the company enters into an offsetting position through a derivative contract which also has a fair value of € 2,000. Since this is an offsetting position, its fair value will move in the opposite direction as that of the hedged item. Example fair value hedge
At the time of the closure of books, the following scenarios are possible: Example fair value hedge
Case #1 – Decrease in the fair value of the hedged item and a simultaneous increase in the fair value of the offsetting hedged instrument
|
Amounts in € |
Position on reporting date |
Value of Hedged Item |
Gain (loss) on Hedged Item |
Value of Hedging Instrument |
Gain (loss) on Hedging Instrument |
|
|
Balance |
||||||
|
A |
B = A – 2,000 |
C |
D = C – 2,000 |
B + D |
||
|
Hedged Item |
Net loss |
1,920 |
-80 |
2,060 |
60 |
-20 |
|
Hedging Instrument |
Net gain |
1,970 |
-30 |
2,040 |
40 |
10 |
|
Hedge relationship |
No loss/No gain |
1,950 |
-50 |
2,050 |
50 |
0 |
Case #2 – Increase in the fair value of the hedged item and a simultaneous decrease in the fair value of the offsetting hedged instrument
|
Amounts in € |
Position on reporting date |
Value of Hedged Item |
Gain (loss) on Hedged Item |
Value of Hedging Instrument |
Gain (loss) on Hedging Instrument |
|
|
Balance |
||||||
|
A |
B = A – 2,000 |
C |
D = C – 2,000 |
B + D |
||
|
Hedged Item |
Net loss |
2,040 |
40 |
1,950 |
-50 |
-10 |
|
Hedging Instrument |
Net gain |
2,050 |
50 |
1,970 |
-30 |
20 |
|
Hedge relationship |
No loss/No gain |
2,050 |
50 |
1,950 |
-50 |
0 |
Example fair value hedge
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