Example of an option on an interest rate swap
The facts of this example are a variation on the previous example. Abbott Corp. anticipates as of June 30, 20X1, that as of June 30, 20X3, it will become a borrower of $5 million with a fixed maturity four years hence (June 30, 20X7). Based on its current credit rating, it expects to be able to borrow at prime + 1/2%. As of June 30, 20X1, it is able to purchase, for a single payment of $25,000, a “swaption” (an option on an interest rate swap), calling for fixed pay at 8% and variable receipt at prime + 1/2%, on a notional amount of $5 million, for a term of four years. The option will expire in two years. At June 30, 20X1, prime is 7.5%.
Note: The interest rate behavior in this example differs somewhat from the prior example, to better illustrate the “one-sidedness” of options, versus the obligation under a swap arrangement or other futures and forwards.
It will be assumed that the time value of the swaption expires ratably over the two years.
This swaption qualifies as a cash flow hedge under ASC 815. However, while the change in fair value of the contract is an effective hedge of the cash flow variability of the prospective debt issuance, the premium paid is a reflection of the time value of money and is thus to be expensed ratably over the period that the swaption is outstanding.
The table below gives the prime rate at semiannual intervals including the two-year period prior to the debt issuance, plus the four years during which ...
