P5 – Interest Rate Swap

Problem 35 – Interest rate swap

On January 1, 2014, Kindall Company received a 5-year, P2,000,000 loan with interest payments occurring at the end of each year and the principal to be repaid on December 31, 2018. The interest rate for the first year is the prevailing market rate of 10%, and the rate in each succeeding year will be equal to the market interest rate on January 1 of that year. In conjunction with this loan, Kindall enters into an interest rate swap payment whereby, in each year of the loan starting 2015, Kindall will receive a swap payment (based on P2,000,000) if the January 1 interest rate is more than 10% and will make swap payment if the rate is less than 10%. The swap payments are made at theend of the year.On January 1, 2015, the interest rate is 12% and on December 31, 2015, the interest is 9%.

Answer/Solution – Explanation

Main Illustration

KINDALL

LENDER

COUNTERPARTY

5 yr P2M loan

Interest at

prevailing market

rate

Interest swap paymentif I < 10%

Interest swap paymentif I > 10%

Answer/Solution – ExplanationRequirement 2

20141-Jan Cash 2,000,000

Loan Payable 2,000,000

31-Dec Interest Expense 200,000 Cash 200,000 P2M x 10% = P200,000 which is the hedged cash flow for interest

Interest Rate Swap Receivable 121,494 Unrealized Gain - Interest Rate Swap 121,494

5 year loan 2,000,000Php Net payment of interest (12%-10%) x 2%Interest swap net payment to be received in each of subsequent 4 years 40,000Php PVIFA 12%, 4 x 3.0373 PV of interest swap net payments to be received 121,494Php

Answer/Solution – Explanation

201531-Dec Interest Expense 240,000

Cash 240,000 (P2M x 12% interest rate at the beginning of the year)

Cash 40,000 Interest Rate Swap Receivable 40,000 Collection of the interest swap payment

Unrealized Gain - Interest Rate Swap 40,000 Interest Expense 40,000 To offset unrealized gain against interest expenseNet interest expense = P240,000 - P40,000 = P200,000 which is the hedged cash flow for interest

Answer/Solution – Explanation

Unrealized Gain - Interest Rate Swap 81494

Interest Rate Swap Receivable 81494

To cancel balance of interest swap receivableand the related unrealized gain because of reduced

interest rate on Dec. 31, 2015

Unrealized Gain, Beg. 121494

Realized Gain during 2015 40000

Unrealized Gain, End 81494

Answer/Solution – Explanation

Unrealized Loss - Interest Rate Swap

50626

Interest Rate Swap Payable 50626

5-year loan 2000000Net Payment of interest (10%-9%) 1%Interest Rate Swap net payment to be paid in each of subsequent 3 years 20000PVIFA (9%, 3) 2.5313PV of interest swap net payments to be paid 50626

Answer/Solution – Explanation

Updating/Adjstment ApproachUnrealized Gain/Loss - Interest Rate Swap (OCI) 132,120 Interest Rate Swap Receivable/Payable 132,120

121,494 40,000 40,000 121,494

81,494 81,494 132,120 132,120

50,626 50,626

Unrealized Gain/Loss - Interest Rate Swap (OCI)

Interest Rate Swap Receivable/Payable