7.9 CASE STUDY: HEDGING A FUTURE FIXED RATE ISSUANCE WITH AN INTEREST RATE SWAP

The aim of this case study is to illustrate the accounting treatment of hedges of highly expected future issuance of fixed rate debt with a forward starting interest rate swap. A forward starting swap is just a swap that starts sometime in the future. With this type of hedge the entity takes advantage of low interest rates prior to issuing the debt and/or does not want to take the risk of higher rates at issuance date.

7.9.1 Background Information

On 1 January 20X0, ABC (an entity with the EUR as functional currency) expected to issue a fixed rate bond on 15 July 20X0 with the following characteristics:

Bond terms
Expected issue date 15 July 20X0
Issuer ABC
Issue proceeds EUR 100 million (100% of notional)
Expected maturity 3 years (15 July 20X3)
Notional EUR 100 million
Coupon Fixed, to be paid annually (30/360 basis)The coupon is expected to be set on the issue date at the EUR 3-year swap rate plus a 100 bps credit spread

ABC was exposed to upward movements in the 3-year swap rate and to a widening of its own credit spread. ABC wanted to protect itself against potential increases in the 3-year interest rate until issuance date, by locking in the future coupon payment at 5.61% (assuming a spread of 100 basis points). Accordingly, on 1 January 20X0 ABC entered into a forward starting receive-fixed pay-floating interest rate swap with XYZ Bank with the following terms:

Interest ...

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