Bob Jensen's Mexcobre Case

How did swaps reduce copper price fluctuation risk?

Introduction

Beginning on January 1, 2001, it is required that all derivative financial instruments be adjusted at least quarterly to fair value under SFAS 133 issued by the Financial Accounting Standards Board (FASB) in the United States and IAS 39 issued by the International Accounting Standards Committee (IASC). These two standards are precursors to stated intents of the FASB and the IASC to require that all financial instruments be marked-to-market in accounting statements. This is an enormous departure from traditional historical cost accounting. The two main objectives of this case are as follows:

To demonstrate to how adjusting many financial instruments to fair value can be more misleading than historical cost.
To challenge students to try to implement SFAS 133 rules in a rather complex and real-world set of international transactions.

Shortly after Salamon Brothers invented the interest rate swap financial instruments derivative in a contract between IBM and the World Bank in 1981, this type of derivative was used to manage risk in a copper mining operation in a Mexican company called Mexicana de Cobre (Mexcobre), a subsidiary of a copper mining group in Mexicao called Group Mexico. The transaction eventually involved ten banks in several nations, a Belgian customer, multiple foreign currencies, and Mexcobre itself.

Why do companies enter into swaps?

In a simple (plain) vanilla swap, the purpose is usually to swap variable rate interest obligations for fixed-rate obligations. The firm with variable rate debt can often swap for a better deal than can be obtained directly on a fixed-rate loan. Reasons for this can be complicated. Sometimes it is a matter of timing. For example, when a firm acquires variable rate debt, that type of debt may appear to be the best deal. With the passage of time, the firm may change its preference toward fixed-rate debt. Negotiating an interest rate swap may have lower transactions cost than paying off the variable rate debt and refinancing with fixed-rate debt. The counter party in the swap, on the other hand, may be willing to speculate or otherwise prefer to swap for variable rate payments.

In more complex situations, there may be capital market inefficiencies that make interest rate swaps advantageous. Firms enter into swaps to either speculate or to hedge interest rate risk. In some instances, fixed-rate debt cannot be obtained directly at any rate. For example, suppose a company has low or even zero credit standing in a certain nation and negotiates to swap interest payments with a company that has high credit standing in that nation. Swaps are often brokered by international banks of high credit standing that eliminate credit risk of both parties to a swap. In any case, swap cash flows are usually netted against each other so the default risk would be low even if there were no payment guarantees. Direct loans often entail credit risk, especially if the borrower is from one nation and the lender is from another nation. Interest rate swaps account for over 70% of all financial instrument derivatives contracts. The reason is that they are a means of reducing credit risk, transactions costs, and market risk in hedging and speculating contracts.

The Mexcobre copper exporting subsidiary of Groupo Mexico faced such enormous financial price risks that it was effectively denied access to international debt markets. At the same time, it was paying a burdensome 23% interest rate to the Mexican Government. Through a complex international swap arrangement, Mexcobre managed to replace its high cost $251 million debt with a 11.48% fixed-rate interest payment that equates to 0.9567% per month.

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How did Sogem from Belgium hedge political risk?

A crucial part of the case came in reducing political risk in Mexico. Since so much labor is involved in copper mining, the Mexican government is not likely to take drastic measures or impose taxes that impede the mining and sale of copper. However, the government might impede cash flows. For example, suppose the Mexican government chooses to tax or otherwise impede interest payments going to the ten banks outside of Mexico in an effort to protect its own loans to Mexican companies. The ten outside banks hedged against such political risk by avoiding cash payments from Mexico. This was accomplished with a purchase contract in which a firm called Sogem in Belgium agreed to purchase nearly 4,000 tons of copper each month at spot rates on the London Mercantile Exchange (LME). Payments, however, went into an escrow account in a New York Bank. These funds, in turn, were used to service $251 million loaned to Mexcobre by ten banks.

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How did a copper swap hedge copper price fluctuation risk?

If copper prices plunged, there was a possibility that the balance of funds in escrow in New York would not be sufficient to service the debt on the $251 million in loans to Mexcobre by ten banks.

mexico3.gif (6260 bytes)

The Bank in New York controlling the escrow account acted at the request of the ten lending banks to hedge against copper price movements. Banque Paribus was willing to swap with the escrow fund for variable copper prices and guarantee a fixed monthly price or $2,000 per ton on 4,000 tons per month.

The contract with Mexcobre capped the return of the New York Banks to 0.9567% per month. Any excess cash from high copper prices above the capped loan rate were returned to Mexcobre.

Case Questions

Question 01
Discuss the various types of risks faced by the ten banks if they simply loaned $251 million to Mexicana de Cobre (Mexcobre) at a fixed interest rate and did not engage in the other contracting mentioned in the case. Discuss both direct and indirect risks. Do not assume any Sogem or Banque Paribus hedging when answering this question.

[Hint: See the term "risk" in Bob Jensen's SFAS 133 Glossary at http://www.trinity.edu/rjensen/133glosf.htm ]

Question 02
Why was Sogem in Belgium hedging contract demanded by the ten banks? Ignore the copper price swap with Banque Paribus when answering Question 2.

Are the hedged items (i.e., the fixed interest payments on the loan to Mexcobre) firm commitments or forecasted transactions? Answer in terms of the notional, underlying, and disincentive for nonperformance on each loan payment.

What implications does this have for the note being a hedged item under Paragraph 21d or 29e of SFAS 133? Can the Sogem hedge affect Other Comprehensive Income (OCI)?

Question 03
Does the net effect of all this transacting result in fixed-rate or variable-rate loan to Mexcobre? Explain your answer in terms of when it is a fixed-rate loan versus when it is a variable-rate loan. Also explain the importance of whether "excess" interest revenues are returned to Mexcobre.

Question 04
After all the contracts in this case are signed, what risks have been assumed by both Banque Paribus and Sogem in Belgium? How can these risks be hedged by Sogem and Banque Paribus? You may assume derivatives not mentioned in this case as well as those mentioned in the case. Explain your answer.

Question 05
In Question 1, you discussed the various types of risks faced by the ten banks if they simply loaned $251 million to Mexicana de Cobre (Mexcobre). Aside from transactions costs in arranging all the contracts (especially the Sogem contract and the Banque Paribus contract), what risks remain to justify charging 11.48% to Mexcobre rather than a much lower interest rate since political risks and copper price risks have been hedged? In other words, why wouldn't the loan be attractive to U.S. banks for 8% which, for example, might be the lending rate to a copper mine in Montana?

Question 06
Can the copper price swap with Banque Paribus be accounted for as a cash flow hedge using SFAS 133 accounting rules? Is the copper price swap to "clearly and closely related" to the contract with Sogem? In addition to SFAS 133 standard criteria for cash flow hedges, add an explaination of your position as to whether this constitutes commodity-indexed interest and principal payments in the context of SFAS 133.

.Hint: See Paragraph 61i on Page 43 of SFAS 133.]

Question 07
In Question 7 and all remaining questions, assume that all ten banks comprise what is called the "New York Bank." You may then account for transactions within only that one bank.

In Question 7 and all remaining questions, assume the New York Bank closes its revenue and expense accounts to Retained Earnings at the end of each month.

For this question, assume there is no $251 million loan to Mexcobre. Instead, you may assume that the bank has some type of income from Sogem that is paid in cash each month equal to the LME spot price of copper multiplied by 4,000 tons each month. In other words, pretend for now that the New York Bank can retain all cash flows from its swap contract with Banque Paribus. Assume the New York Bank in this instance chooses to account for the copper swap as a cash flow hedge under SFAS 133 (ignoring any argument that SFAS 133 might not apply). You are to make journal entries for only the copper price hedge between the New York Bank and Banque Paribus. Ignore the fact that ten banks are involved and assume all net swap payments flow to or from the New York Bank. Also ignore arguments such as those given in Question 2 that the note may not qualify as a hedged item under SFAS 133 criteria for hedged items.

What is the journal entry made by the New York Bank at the date the swap is initiated on January 1, 19x1? What is the entry made on January 31, 19x1 by this bank to record the cash payment from Sogem in Belgium for 4,000 tons of copper at $1,850 per ton? Limit your answer to the swap accounting and do not attempt to account for loan of $251 million in this question or the return of any surplus payments to Mexcobre. Assume that in the first month, the Banque Paribus honors its swap obligation by sending the New York Bank a check for the net difference between $2,000 per ton versus the spot price of $1,850 per ton for 4,000 tons of copper. What is the journal entry for the New York Bank to account for the swap payment? What are the journal entries for Banque Paribus at the inception of the swap on January 1, 19x1 and after the first net swap cash payment on January 31, 19x1?

Assume the books are closed at the end of each month and show the closing entry to Retained Earnings as well as the closing balance in retained earnings assuming no other transactions.

Repeat the January 31 entries for February 28 and March 31 net cash flows from both the Sogem and Banque Paribus contracts. Accumulate the balances for Cash, Other Comprehensive Income, and Retained Earnings from the January 31 balances. Assume that the LME copper spot prices are $2,100 for February and $2,400 for March on 4,000 tons of copper each month.

When making the SFAS 133 journal entries for the swap, use the data in the following table:

Month	Current Copper Price/ton	Swap Receivable Price	Net Price Difference	Journal Entry Date	Copper Swap Cash Flow	Assumed Swap Value
				01/01/x1		$0
1	$1,850	$2,000	$150	01/31/x1	$600,000	$16,942,276
2	$2,100	$2,000	($100)	02/28/x1	($400,000)	($11,064,274)
3	$2,400	$2,000	($400)	03/31x1	($1,600,000)	($43,320,951)

In Question 7, restrict your entries to cash flows from Sogem and the SFAS 133 entries for the copper price swap. Entries for the Mexcobre note will be made in a later question.

Please use the following Chart of Accounts in your journal entries:

Cash
Copper price swap receivable/payable
Interest expense/revenue (this account is not used in Question 7)
Loss/gain on copper price speculation (use this account for all cash flows in Question 7)
Other comprehensive income
Retained earnings

Question 08
Now you are to return to the case involving the loan to Mexcobre and the copper price swap.

Please derive the $251 loan amortization schedule across for a fixed-rate of 11.48% APR or a 0.9567% fixed monthly rate for 38 months. In a spreadsheet, show the interest expense, principal reduction, and total loan payment each month that is deducted from the cash payments from Sogem and Banque Paribus. Also show the "excess" cash each month if the copper price swap yields $8.0 million each month to service the amortized sum of the principal and interest portions that total $7,909,666 each month. Discuss why the loan would probably not be periodically remeasured to market value under SFAS 115 rules. Why might this not affect having to remeasure the copper price swap to market value on the books of the bank? (Your instructor may prefer to provide you with this loan amortization schedule so that all students work with the same schedule.)

Question 09

Compute the breakeven price of copper for which the New York Bank will exactly earn its contracted 0.9567% per month. Then comment on the impact of varying copper prices when surplus funds above the breakeven copper price are returned versus not returned to Mexcobre.

Please draw two graphs comparing the monthly increase in cash versus the monthly increase in retained earnings for January 31, February 28, and March 31. Also show the pattern of the change in the value of the copper price swap beside the changes in cash and retained earnings from these transactions. You only need to graph the first three months.

Graph 1: Assume a copper price swap with a return of cash flows in excess of $7,909,666 per month.

Graph 2: Assume a copper price swap with no return of cash flows in excess of $7,909,666 per month.

Please draw two additional graphs comparing the monthly retained earnings balances with versus without a copper price swap. Assume the copper prices given in Question 7.

Graph 3: Change in Retained Earnings with versus without a swap and return of cash flows in excess of $7,909,666 per month.

Graph 4: Change in Retained Earnings with versus without a swap no return of cash flows in excess of $7,909,666 per month.

At the end of your answers to Question 8, discuss whether this copper price swap was effective in terms of SFAS 133 criteria for hedge effectiveness. Explain your answer.

Question 10
For this question, assume that the one New York Bank loaned the entire $251 million to Mexcobre under the terms spelled out in the case. In Question 10 you are to assume that the copper price swap satisfies all SFAS 133 requirements to be a cash flow hedge of the cash flows from Sogem in Belgium. Unlike in Question 7, assume that surplus funds from high copper prices are returned monthly to Mexcobre above and beyond the 11.48% interest rate that equates to 0.9567% per month. Also limit your answer to the contract to loan $251 million, the contract between the New York Bank and Sogem, the contract with Banque Paribus, and the return of surplus funds to Mexcobre. Assume that the loan principal is amortized over 38 months much like mortgage note amortization in the calculation of loan payments to the New York Bank at 0.9567%. In other words, each net swap payment from the Banque Paribus is to be added to the Sogem payments. At the end of each month, the New York Bank deducts a monthly loan payment from the fund accumulated variable payments from Sogem and the net swap payments from Banque Paribus. Any surplus is then sent to Mexcobre each month.

In summary, you are to make the New York Bank's journal entries for the following:

$251 million loan to Mexcobre on January 1, 19x1;

the Banque Paribus swap cash flow hedge contract on January 1, 19x1;

the variable monthly payments from Sogem on January 31, February 28, and March 31 assuming 4,000 tons per month at spot prices of $1,850 per ton in January, $2,100 per ton in February, and $2,400 per ton in March;

the monthly net copper swap receipts or payments from Banque Paribus on January 31, February 28, and March 31 on fixed swap receipts of $2,000 per ton and swap payments at the same prices used by Sogem to transmit the payments each month;

the first three loan payments (principal and interest) from the escrow fund to the New York Bank on January 31, February 28, and March 31, 19x1;

the three monthly surplus payments to Mexcobre in 19x1.

When making the SFAS 133 journal entries for the swap, please use the Question 7 data table.

Please use the following Chart of Accounts in your journal entries:

Cash
Copper price swap receivable/payable
Notes receivable - Mexcobre
Interest expense/revenue (this account is not used in Questions 7 and 8)
Loss/gain on copper price speculation (use this account only in Questions 7, 8, and 12)
Accounts payable - Mexcobre (in Question 10, any surplus funds are sent to Mexcobre monthly)
Even if surplus funds are transferred the same day they are received, please run them into
Accounts payable - Mexcobre and then settle the account in a separate entry.
Retained earnings

Hint: In Question 10 and Question 12, when cash is received from Sogem in Belgium, debit Cash and credit Accounts Payable - Mexcobre. When that payable is zeroed out each month, debit the payable and credit a combination of Interest Revenue, Notes Receivable, and Cash (for the excess cash sent to Mexcobre). In Question 10 when cash is received from Banque Paribus, debit Cash and credit Accounts Payable - Mexcobre. This is not an issue in Question 12 since there is no copper price swap with Banque Paribus in Question 12.

Question 11
Compute and compare the rate of return to the New York Bank in Question 10 for each of the first three months. Compare this with the rate of return that would be obtained each month if the surplus funds were not returned to Mexcobre. First assume the copper price swap is in effect and provide the rate of return with or without return of cash flows above the 0.9567% per month cap.

Next perform similar calculations assuming no copper price swap. In order to simplify the calculation of the rate of return with no copper price swap, compute each month's rate of return as the ratio of that month's net income from the Mexcobre transactions divided by the beginning balance of the note's principal still outstanding. You are to compare the solutions with versus without transfer of surplus funds to Mexcobre.

In summary, you are to provide answers in the following tables:

January of Year 1	Assuming the Interest Cap	Assuming No Interest Cap
Assuming Return of Excess Cash	?	?
Assuming No Return of Excess Cash	?	?

February of Year 1	Assuming the Interest Cap	Assuming No Interest Cap
Assuming Return of Excess Cash	?	?
Assuming No Return of Excess Cash	?	?

March of Year 1	Assuming the Interest Cap	Assuming No Interest Cap
Assuming Return of Excess Cash	?	?
Assuming No Return of Excess Cash	?	?

Question 12
Repeat the January, February, and March answers for Question 10 assuming that there is no copper price swap with Banque Paribus. In order to simplify the calculation of the rate of return in Question 12, compute each month's rate of return as the ratio of that month's net income from the Mexcobre transactions divided by the beginning balance of the note's principal still outstanding. You are to compare the solutions with versus without transfer of surplus funds to Mexcobre. In other words, you must provide two alternative sets of journal entries. Assume that the surplus funds sent each month are either zero (if the copper price declines below the breakeven point) or positive (equal to the surplus above the monthly breakeven point).

A major question here is whether to include the increments to Other Comprehensive Income (OCI) in the numerator of the rate of return calculations when surplus funds are not returned to Mexcobre. For Question 12, please add OCI increments to the numerator of the rate of return calculations.

Make all journal entries for the contracts with Mexcobre and Sogem. Assume that the note is maintained under amortized historical cost and is not adjusted for fair market value. Then compare all your journal entries for Question 12 versus Question 10. Please discuss the impact of the swap on the New York Bank.

After you finish the journal entries, compute the breakeven price of copper for which the New York Bank will exactly earn its contracted 11.48% per year or 0.9567% per month. Then comment on the impact of varying copper prices when surplus funds above the breakeven copper price are returned versus not returned to Mexcobre.

When making the SFAS 133 journal entries for the swap, please use the Question 7 data table.

Please use the same account names that are listed in the Chart of Accounts for Question 10.

In Question 12, assume that the Notes Receivable - Mexcobre account will always be credited with the loan amortization principal reduction from Question 10 no matter what the price of copper on the cash settlement date with Sogem in Belgium. In other words, all price fluctuations above and below the break-even price of copper affect interest revenue and cash settlements with Mexcobre. These price fluctuations do not affect the principal reductions on the note.

Question 13
From an accounting theory standpoint, do you think SFAS 133 accounting for the Mexcobre transactions would help investors more easily analyze the risk management practices of the New York Bank? (One bank was assumed in Questions 7-12 in order to simplify the case.)

If either the Sogem or the Banque Paribus contracts are booked and adjusted to fair value (no matter what the rules are under SFAS 133 or IAS 39), do you think that adjusting to fair value will help or hinder investor analysis of the New York Bank?

When answering this question, first present arguments on both sides of each issue. Then reason out your own conclusions.

Lastly, you are to discuss how the accounting would differ under IAS 39 versus SFAS 133.