In 2015, FFC invested in the common stock of Company X, a privately held clothing retailer that
Question:
In 2015, FFC invested in the common stock of Company X, a privately held clothing retailer that operates in a niche market of the baby clothing industry. Quoted prices are not available for X’s stock. 2 Most of X’s competitors are either privately held or subsidiaries of larger publicly traded clothing retailers. Company X is similar to two other organizations whose shares are thinly traded in an observable market.
2 Note that the security does not have a readily determinable fair value and thus is not in the scope of ASC 320, Investments — Debt and Equity Securities . However, FFC has elected the fair value option for the security in accordance with ASC 825, Financial Instruments , and thus accounts for the investment at fair value with changes in fair value recorded through earnings.
In determining an appropriate approach for measuring the fair value of its equity investment in X, FFC considered the following factors to establish whether a single or multiple valuation techniques should be adopted:
• Availability and reliability of data — FFC had sufficient data to support both the income and market approaches.
• Comparative levels of the alternative approaches in the fair value hierarchy — When using a market approach to measure the fair value of its investment in X, FFC would need to make significant entity-specific adjustments to observable market transactions (i.e., risk-adjustments for illiquidity, uncertainty of X’s future financial performance in relation to its comparables, and other adjustments to reflect business model differences between X and its comparables). Similarly, when measuring fair value using an income approach (on the basis of discounted cash flows), FFC would be required to use significant entity-specific assumptions in forecasting X’s future cash flows.
• Views of market participants on the relevance of valuation techniques — Through discussions with valuation specialists, FFC believes that market participants use multiple techniques (income and market approaches) to determine bid prices for similar investments. FFC also used both approaches in 2015 when pricing its investment in X.
Considering this information, in 2015 FFC determined that it would use both market and income approaches (weighted equally) to measure the fair value of its investment in X. FFC has applied a consistent approach during 2016.
3 — Interest Rate Swap
In January 2015, FFC executed a “plain-vanilla” over-the-counter (OTC) fixed-for-float interest rate (IR) swap as an economic hedge of its cash flow variability to changes in the London Interbank Offered Rate (LIBOR) on its six-year variable-rate term note. The terms of the IR swap require FFC to pay a fixed rate and receive a floating rate (three-month LIBOR). The IR swap net cash settles on a quarterly basis. If the fixed rate exceeds the floating rate, FFC makes a net payment to the counterparty, and if the floating rate exceeds the fixed rate, FFC receives a net payment from the counterparty. As of the measurement date (December 31, 2016), the remaining life of the IR swap was four years.
FFC uses an income approach (i.e., a discounted cash flow model), which is widely accepted for valuing IR swaps. Key inputs into the valuation model are the LIBOR yield curve and an adjustment, if any, for nonperformance risk, which is the risk that a party to the contract will not satisfy its obligation (also known as a credit valuation adjustment (CVA)). FFC obtained a quoted LIBOR yield curve for the entire term of the IR swap. In addition, FFC concluded that no CVA was necessary on the basis of (1) the creditworthiness of both FFC and the IR swap counterparty and (2) credit enhancements related to the IR swap by virtue of the International Swap Dealers Association agreement between FFC and the IR swap counterparty.
An active OTC market exists for IR swaps having the same underlying (three-month LIBOR) and tenor (five years) as FFC’s IR swap.
4 — Fuel Swap — Gasoline
In January 2016, FFC entered into a four-year fixed-for-float OTC fuel swap. The terms of the fuel swap require FFC to pay a fixed price and receive a floating price from the counterparty according to the monthly average of a U.S. unleaded gasoline price published on the last day of the month by an independent source. The fuel swap settles annually on the last business day of each calendar year. If the fixed price exceeds the floating price (i.e., the 12-month average of the immediately preceding 12 months’ (January through December) published unleaded gasoline prices), FFC makes a net payment to the counterparty; if the floating price exceeds the fixed price, FFC receives a net payment from the counterparty. As of the measurement date (December 31, 2016), the remaining life of the fuel swap was three years.
FFC uses an income approach (i.e., a discounted cash flow model), which is widely accepted for valuing fuel swaps. Key inputs into the valuation model are the forward U.S. unleaded gasoline price curve and a CVA, if any.
An inactive OTC market exists for fuel swaps having the same underlying (U.S. unleaded gasoline) and tenor (three years) as FFC’s fuel swap. FFC was able to obtain an independently quoted U.S. unleaded gasoline forward price curve for one of the three years remaining under the swap. For the last two years of the swap, FFC used a forward curve obtained from a third-party pricing service. The third-party pricing service constructs the forward curve by using a proprietary model that incorporates fundamental economic factors such as physical constraints (e.g., capacity of current and future refining plants) and projected global supply and demand. As of the measurement date, the third party has not observed U.S. unleaded gasoline swap transactions with tenors beyond one year. In addition, FFC has calculated a CVA using unobservable inputs (and the counterparty was recently downgraded by S&P).
Investment Analysis and Portfolio Management
ISBN: 978-0538482387
10th Edition
Authors: Frank K. Reilly, Keith C. Brown