Question: Swap contracts are a type of derivative that is often

Swap contracts are a type of derivative that is often used to manage financing costs. To illustrate, suppose a firm has $ 200,000 of 10% bonds outstanding at December 31, 2010. Interest is payable semi- annually, and the bonds mature three (semi-annual) periods hence, on June 30, 2012.
The variable market interest rate on December 31, 2010, is also 10% per annum. However, the firm suspects that variable interest rates will decline, and it enters into a swap contract with a financial institution under which the firm receives $ 10,000 at the end of each period (i. e., equal to its 5% semi- annual fixed interest payments on its debt) and agrees to pay to the financial institution each period interest on its debt at the end-of- period variable rate (currently 5% per period).
On December 31, 2010, the fair value of this contract is zero, since the market variable interest rate equals the interest rate on the bonds. This is verified as

This amount is the same as the present value of the remaining fixed interest payments on the bonds. That is, the expected receipts and payments under the swap are equal.
Of course, the fair value of the swap will change over time as the variable rate varies. Suppose that at the end of the first period the variable rate is 8% per annum. Then the firm receives $ 10,000 as before and pays $ 8,000 per period under the swap contract.
The fair value of the firm’s debt rises to $ 203,772. However, to compensate, the fair value of the swap rises from zero to $ 3,772:

The $ 2,000 numerators represent the $ 10,000 payments to be received by the firm less the expected $ 8,000 payments out, over the remaining life of the contract. Thus the firm’s net liability remains at $ 200,000 and its interest expense for the period is $ 8,000 ($ 10,000 interest paid on bonds less $ 2,000 net cash received under swap contract).
Now change the example. Specifically, assume that the firm is Country G, a member of the European Union (EU). EU rules include a requirement that member countries’ ratio of deficit to gross domestic product cannot exceed 3%. Country G is concerned that its ratio will exceed 3%.
Country G enters into a swap contract with a financial institution on December 31, 2010, similar to the one described above, except that it will receive a payment of $ 15,000 each period, rather than $ 10,000. Since this payment greatly exceeds the country’s expected variable rate payments of $ 10,000, the fair value of the swap contract increases from zero to $ 13,616.
The financial institution now pays Country G this fair value. Consequently, the swap contract disappears from Country G’s financial statements. In return for the $ 5,000 increased payment to be received each period, Country G agrees to pay over to the institution the receipts from its airport landing fees and lottery proceeds for two years following the expiry of the swap contract.
EU rules allow the $ 13,613 payment to be credited to revenue, instead of being recorded as a liability. Country G thus avoids violating the 3% rule in 2010.

a. Verify that the fair value of Country G’s swap contract on December 31, 2010, is $ 13,616.
b. From an accounting perspective, do you agree that the $ 13,616 payment of Country G is revenue, rather than a liability?Explain.

Sale on SolutionInn
  • CreatedSeptember 09, 2014
  • Files Included
Post your question