Question

CMOS Chips is hedging a 20-year, $18 million, 9% bond payable with a 20-year interest rate swap and has designated the swap as a fair value hedge. The agreement called for CMOS to receive payment based on a 9% fixed interest rate on a notional amount of $18 million and to pay interest based on a floating interest rate tied to LIBOR. The contract calls for cash settlement of the net interest amount on December 31 of each year.

At December 31, 2021, the fair value of the derivative and of the hedged bonds has increased by $108,000 because interest rates declined during the reporting period.

Required:
1-a. Does CMOS have an unrealized gain or loss on the derivative for the period?
1-b. Does CMOS have an unrealized gain or loss on the bonds?
1-c. Will earnings increase or decrease due to the hedging arrangement?
2. Suppose interest rates increased, rather than decreased, causing the fair value of both the derivative and of the hedged bonds to decrease by $108,000.
a. Would CMOS have an unrealized gain or loss on the derivative for the period?
b. Would CMOS have an unrealized gain or loss on the bonds?
c. Would earnings increase or decrease due to the hedging arrangement?
3. Suppose the fair value of the bonds at December 31, 2021, had increased by $136,000 rather than $108,000, with the additional increase in fair value due to investors’ perceptions that the creditworthiness of CMOS was improving.
a. Would CMOS have an unrealized gain or loss on the derivative for the period?
b. Would CMOS have an unrealized gain or loss on the bonds?
c. Would earnings increase or decrease due to the hedging arrangement?
4. Suppose the notional amount of the swap had been $20 million, rather than the $18 million principal amount of the bonds. As a result, at December 31, 2021, the swap’s fair value had increased by $136,000 rather than $108,000.
a. Would CMOS have an unrealized gain or loss on the derivative for the period?
b. Would CMOS have an unrealized gain or loss on the bonds?
c. Would earnings increase or decrease due to the hedging arrangement?
5. Suppose BIOS Corporation is an investor, having purchased all $18 million of the bonds issued by CMOS as described in the original situation above. BIOS is hedging its investment, classified as available-for-sale, with a 20-year interest rate swap and has designated the swap as a fair value hedge. The agreement called for BIOS to make payment based on a 9% fixed interest rate on a notional amount of $18 million and to receive interest based on a floating interest rate tied to LIBOR.
a. Would BIOS have an unrealized gain or loss on the derivative for the period due to interest rates having declined?
b. Would BIOS have an unrealized gain or loss on the bonds?
c. Would earnings increase or decrease due to the hedging arrangement?
  

Answer 1

Bond Payable	18000000		Derivative	f+
Interest Rate	9%		Receivable	9% Fixed Rate
Tenure (Years)	20		Payable	LIBOR/ Fair Value
1a)
Unrealised Gain on Derivative	$108000
(Due to upside betting)
1b)
Unrealised Loss on Bond
(Due to increase in value of Bond Payable)	-$108000
1c) Earning will remain unchanged as Gain in derivatve will be setoff with
the loss in bond
2a)
Unrealised Loss on Derivative	-$108000
(Due to upside betting)
2b)
Unrealised Gain on Bond
(Due to increase in value of Bond Payable)	$108000
2c) Earning will remain unchanged as Loss in derivatve will be setoff with
the Gain in bond
3a)
Unrealised Gain on Derivative	$108000
(Due to upside betting)
3b)
Unrealised Loss on Bond
(Due to increase in value of Bond Payable)	-$136000
3c) Earning will decrease by $28000 as the loss in bond is more than the
gain in derivative.
4a)
Unrealised Gain on Derivative	136000
(Due to upside betting)
4b)
Unrealised Loss on Bond
(Due to increase in value of Bond Payable)	-108000
4c) Earning will Increase by $28000 as the loss in bond is Less than the
the Gain in bond
5a)
Unrealised Loss on Derivative	-108000
(Due to Downside betting)
5b)
Unrealised Gain on Bond
(Due to increase in value of Bond Receivable)	108000
5c) Earning will remain unchanged as Gain in derivatve will be setoff with
the loss in bond