Help please

cornflower

I have just passed ACCA P2 and my boyfriend has asked me for help on this question as he is studying MSC in Accounting but I'm totally baffled by it. It's on hedge accounting and whether a hedge is effective or not. If anyone can help I'd be most grateful. Here is the question:

Entity A has a C1000 debt at 10% fixed rate with a 2 year term. Interest payments are made annually. In order to hedge against future changes in interest rates it enters into a 2 year C1000 notional interest rate swap requiring interest payments at 1 year LIBOR in exchange for the receipt of fixed interest at 10%. At inception LIBOR is expected to be 10% for the following 2 years but at the end of year 1 it is expected to be 5% for the 2nd year.

Perform a hedge effectiveness test at the end of year 1 in accordance with IAS39 principles.

cornflower

Sorry but I have posted in wrong forum as well.

Steve Collings

Hi,

It's been a while since I did a hedge calculation, but here goes!

At the end of year 1 your retrospective test would be as follows:

Hedged item:
Fair value at inception.....................................1,000
Fair value at end of year 1:
C1,000 x 1.10/1.05.........................................1,048
Change in fair value...........................................(48)

Hedging instrument:
Fair value at inception..........................................0
Fair value at end of year 1 = C50 / 1.05................48
Change in fair value............................................48

The C50 is the difference in anticipated swap cash flows (C1,000 x (10% - 5%))

Offset test at the end of year 1

Change in fair value of heding instrument / change in fair value of hedged item, so:

48 / 48 = 1.

The hedge is currently 100% effective.

The chances are that if there had been a contractual diff, or a delay in the timing of cash flows (either on the debt or the swap), or if hedge effectiveness is tested at a date other than the swap repricing date then there would undoubtedly be some hedge ineffectiveness. In your Q also there is no mention of any credit risk in the swap payments and such credit risk also has the potential of introducing some ineffectiveness.

Hope that helps.

Steve

cornflower

Thanks so much Steve