Exercise 1:

On January 3, Year 1, VB Technical Inc. borrowed $5,000,000 from BankAmerica. The loan has a 5-year term and a 6% fixed interest rate. Interest is payable semiannually on June 30 and December 31 of each year. On the same day, VB entered into an interest rate swap agreement with Last Bank Financial. The swap agreement specifies that VB will receive a fixed rate payment of 6% and pay a floating (variable) rate at Libor to Last Bank based on a $5 million notional amount. The net cash settlement dates (for differences in interest payments between VB Technical and Last Bank Financial) on the swap are also semiannual on June 30 and December 31 of each year.

Assume that interest rates increased steadily during Year 1. Also assume the following information as of June 30, Year 1:

1. VB paid $37,500 to Last Bank as a cash settlement based on the difference in interest payments related to the swap.
2. The fair value of the swap contract was negative at $(122,000), and
3. The fair value of the loan from BankAmerica (due to interest rate changes) was $4,878,000.

Required:

1. Briefly explain the purpose of the above swap agreement and the specific risk that VB Technical is hedging.

2. Prepare the journal entry by VB Technical to record the execution of the swap contract on January 3, Year 1.

3. Prepare the journal entry to record the payment of interest expense on the loan payable to BankAmerica on June 30, Year 1.

4. Prepare the journal entry to record the net cash settlement on the swap with Last Bank Financial on June 30, Year 1.

5. Prepare the journal entry to record the change in the fair value of the swap contract on June 30, Year 1.

6. Prepare the journal entry to record the change in the fair value of the loan payable on June 30, Year 1.

7. What amounts would be reported on (a) the Balance Sheet, and (b) the Income Statement of VB Technical on June 30, Year 1 related to the above activity