Question

LLB Industries borrowed $310,000 from Trust Bank by issuing a two-year, 10% note, with interest payable quarterly. LLB entered into a two-year interest rate swap agreement on January 1, 2021, and designated the swap as a fair value hedge. Its intent was to hedge the risk that general interest rates will decline, causing the fair value of its debt to increase. The agreement called for the company to receive payment based on a 10% fixed interest rate on a notional amount of $310,000 and to pay interest based on a floating interest rate.

Floating (LIBOR) settlement rates were 10% at January 1, 8% at March 31, and 6% at June 30, 2021. The fair values of the swap are quotes obtained from a derivatives dealer. Those quotes and the fair values of the note are as indicated below. The additional rise in the fair value of the note (higher than that of the swap) on June 30 was due to investors’ perceptions that the creditworthiness of LLB was improving.

	January 1			March 31			June 30
Fair value of interest rate swap		0		$	7,572		$	13,594
Fair value of note payable	$	310,000		$	317,572		$	330,000

Required:
1. Calculate the net cash settlement at June 30, 2021.
2. Prepare the journal entries on June 30, 2021, to record the interest and necessary adjustments for changes in fair value.

There are 4 journal entries.

Answer 1

Summary:

As per foward rate agreement one party feel interest rate will rise, so it better to lock into fixed rate payment and other party feel interest rate will decline, so it better to pay floating rate. The calculation is based on net settlement basis (For eg Party A have to pay 10$ to Party B and Party B has to pay 8$ so net settlement will be Party B will end up paying 2$)

Explanation

The Industries is fixed rate payor and expect that interest rate will decline so he entered into FRA 90 day libor with other counterparty who feel interest will rise

For explanation Industries will be termed "A" and other counterparty will called "B"

For calculation, Libor is always taken T-1, so if we want to calculate the cash settlement for March 31st will be take libor of January   

On 31st March :Net Cash settlement will be zero, since both the parties have to pay equal amount

On June 30 : Cash settlement will 1,550$ will be paid by B, since Interest has fallen (Libor of March 31)

Formula to Calculate:

Net Fixed Payment: (Fixed rate- libor t-1)* (No of Days/360)*Notional principal

If answer is postive Fixed rate payer will pay to Floating

If negative fixed rate will receive the payment

Concusion:

Party A has benefited from these FRA as Libor has decereased so rather then paying 7,750$ on fixed rate loan, he will paying only 6,200$ (7,750$-1,550$).Whereas party B has suffered loss of 1000$.In contract one party Loses and party benefit from the contract .

Journal Entry :

Date	Particulars	Debit	Credit
30 Jun 2021	Cash A/c	1,550
	Derivative Dealer (Net receivable entry		1,550

Thank You