Transcription of Interest Rate Swaps – example 11
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Example: bankruptcy
Interest Rate Swaps – example 11
Interest Rate Swaps example 11. example 11: Using a floating for fixed Interest rate swap to hedge out cash flow risk Entity A issued 5 year bonds on 1 January 2010 for R1 million. The bonds bear Interest at prime +. 2% per annum, paid semi-annually in arrears. The bonds are measured at amortised cost. On 1 July 2011, the financial manager was of the view that Interest rates were increasing and consequently decided to hedge out potential losses of having to pay high market Interest rates . Expected Interest rates Interest rates Fixed Interest rate time What risk relating to the fixed Interest rate on the bond, is entity A exposed to (fair value or cash flow) and why? On 1 July 2011, the financial manager entered into a two year Interest rate swap agreement with a notional amount of R1 million. In terms of the Interest rate swap agreement, the entity will receive a 6 month floating Interest rate of prime + 2% and pay a fixed semi-annual Interest rate of 7%. Assume that net payments on the swap agreement are settled every six months, at which date the variable rate payable during the following six months is set.
Total interest expense for the year ended 31 December 2011 R Effective interest rate on bond -125 000 Interest effect of hedge -5 000-130 000 This hedge is perfectly effective. The total interest expense reported represents interest at a floating rate of 6.0% for 6 months (unhe dged) and interest at a fixed rate of 7% for the second
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