Section 1:            Hedging the Benchmark Interest Rate

In the United States, hedging the benchmark rate of interest refers to hedging either the risk-free rate or the LIBOR swap rate.  An example of a fair value hedge of the LIBOR swap rate is provided below.

Example:  Fair Value Hedge of the LIBOR Swap Rate in a $100 Million A1-Quality 5-Year Fixed-Rate Noncallable Debt

On April 3, 20X0, Global Tech issues at par a $100 million A1-quality 5-year fixed-rate noncallable debt instrument with an annual 8 percent interest coupon payable semiannually. On that date, Global Tech enters into a 5-year interest rate swap based on the LIBOR swap rate and designates it as the hedging instrument in a fair value hedge of the $100 million liability.  Under the terms of the swap, Global Tech will receive a fixed interest rate at 8 percent and pay variable interest at LIBOR plus 78.5 basis points (current LIBOR 6.29%) on a notional amount of $101,970,000 (semiannual settlement and interest reset dates).  A duration-weighted hedge ratio was used to calculate the notional amount of the swap necessary to offset the debt’s fair value changes attributable to changes in the LIBOR swap rate.

·        PV01 debt = 4.14

·        PV01 swap = 4.06

·        Hedge ratio = PV01 debt / PV01 swap = 4.14/4.06 = 1.0197

·        Swap notional = 1.0-197 x $100 million = $101,970,000

The example assumes that the LIBOR swap rate increased 100 basis points to 9 percent on June 30, 20X0.  The change in fair value of the swap for the period from April 3 to June 30, 20X0 is a loss of $4,016,000.  The change in fair value of the debt attributable to changes in the benchmark interest rate for the period April 3 to June 30, 20X0 is calculated as follows:

As of June 30, 20X0, 9.5 periods remain and the cash flows are discounted at 9 percent; determined as the initial 8-percent yield plus a 100 basis point increase attributable to the 100 basis point increase in the LIBOR swap rate.  The accrual for the first quarter interest was excluded.  The following journal entries illustrate the swap and debt fair value changes, attributable to changes in the LIBOR swap rate, excluding accruals:

Dr. Debt                                               3,775,620

            Cr. Earnings                                                           3,775,620

Dr. Earnings                                         4,016,000

            Cr. Swap liability                                        4,016,000

The net earnings impact of the hedge was $240,380 due to some imprecision in the calculated hedge ratio.